Dividend Explanation
Important Dividend Ratios
While a high dividend yield can be tempting, savvy investors know that the sustainability of that payment is far more important. How do you look beyond the yield to assess a company’s true financial health? The answer lies in analyzing key dividend ratios. These simple calculations, like the payout ratio, provide critical insight into whether a company can truly afford its dividend payments, especially during tough economic times.
Understanding these metrics is the difference between securing a reliable income stream and chasing a yield that’s destined to be cut. For a complete review of dividends, explore our guide on dividend investing and income.
Common Dividend Yield Calculations
Dividend yields are a good way to determine if a stock aligns with investment objectives. A low dividend yield may indicate that the company is focused on growth. While a higher dividend yield often indicates that the company is established and mature. However, there is a balance. An excessively high dividend yield could be a red flag if the dividend yield has increased simply because there has been a precipitous decline in the stock’s price. As you approach double-digit dividend yields, it becomes nearly impossible for a company to support the payment for the long-term.
Dividend Per Share (DPS)
DPS provides a simple answer to the question, “How much money will I make?” It helps you determine how much income you will receive on a per-share basis.
One formula to calculate DPS is Total Dividends Paid divided by Shares Outstanding. For example, if a company announced a total dividend of 1 million dollars to be paid to shareholders and there are currently 2 million shares outstanding, the DPS would be $0.50.
Dividend Yield
Dividend Yield measures the percentage of a company’s market price per share that is paid to shareholders in the form of dividends. In other words, it shows the percentage of dividends represented in every dollar of stock.
You can think of a dividend yield like an interest rate. It is a percentage of your holding that you will receive for owning the stock. Although the DPS may remain stable, dividend yields will fluctuate since stock prices are constantly changing.
The formula for dividend yield is the dividend per share divided by market value per share (current share price).
Trailing and Forward Yield
Dividend Yield can also be viewed as either forward or trailing. Forward dividend yield is a projection of the annual dividend amount investors will receive. It is expressed as a percentage of the current share price and is calculated by annualizing the most recent dividend payment. It is best used when a company has a history of consistent or increasing dividend payments and is therefore likely to continue to pay a regular dividend payment over the next 12 months.
When a company has a history of inconsistent dividend payments, it is best to use the trailing yield. Tailing yield is calculated like Forward Yield, except it uses actual DPS over the previous 12 months instead of just the last dividend payment.
Yield on Cost (YOC)
YOC is very similar to dividend yield, but it uses your cost basis to determine yield instead of the current share price. It is calculated by dividing your annual DPS by your cost basis per share. For example, let’s say you have 100 shares of a stock that has an annual dividend per share of $3.60 or $0.90 quarterly. And we will say that your cost basis is $40 per share. In this example, your YOC would be 9% annually.
Now, if you want to calculate your Dividend Yield, you will use the current share price, which we will say is $48. So, your DY would be 7.5%. In this example, your YOC would be 9%.
When you use YOC, you must adjust your cost basis each time you buy new shares. It can become very high if the stock price appreciates a lot after your purchase. So, YOC is more useful on long-term holdings when the current price is significantly different than the current price.
While YOC is important to evaluate your existing holdings, it is not useful when you are evaluating new stocks to add to your account.
After-tax Yield
After-Tax Yield is used to compare income on securities taxed at different rates, like ordinary or qualified. Simply stated, it is your dividend yield reduced by your tax rate. Let’s compare a security that pays an ordinary dividend to a Qualified dividend from a common stock.
A popular REIT pays $5 per share and a stock pays $4.50 per share. REITs are typically taxed at your ordinary tax rate which we will estimate as 25% for this example. A stock dividend meeting certain criteria can be a Qualified Dividend taxed at 15%. Your take-home income on the REIT would be $3.75, and the stock’s income would be $3.83. Even though the REIT has a higher payment because it is taxed at a higher rate, the final income of the stock is higher.
Keep in mind that the dividend yield ratio varies significantly from industry to industry. Comparisons between companies should only be made within the same industry.
Financial Health Metrics
In addition to ratios that focus on yield, it is important to have a working understanding of ratios that allow you to quickly analyze a company’s financial health and valuation compared to others.
Earnings Per Share (EPS)
EPS is an indication of a company’s profitability. It represents the portion of a company’s profit that is allocated to every individual share of the stock. And as such, is a measurement of a company’s value. It is often used when investors are determining whether to buy shares.
The basic formula for EPS is net income minus preferred dividends divided by the number of outstanding shares.
Diluted EPS
A better way to view EPS is to use the Diluted EPS, which measures a company’s value if all its convertible shares were exercised. In other words, Diluted EPS is “diluted” by all potential shares outstanding and will be equal to or lower than basic EPS. Diluted EPS is useful because it shows a worst-case scenario for shareholders.
To calculate the diluted EPS, you would subtract Preferred Dividends from a company’s net income and then divide by average outstanding shares plus dilutive shares.
Earnings Per Share (EPS)
P/E Ratio helps determine if a stock represents a good value. It can also be used to compare a stock’s current value to its past or projected future. Keep in mind, a low share price on its own does not mean that a company is undervalued.
A stock is undervalued when it has a low share price relative to how much the company earns. Every company has a different share price, different number of shares issued, and different earnings, so the P/E Ratio offers a good measuring stick to easily compare companies.
Share price divided by EPS is the P/E Ratio formula. It is expressed in terms of times. For example, if a stock has a share price of $50 per share and its EPS is $5 per share, its P/E Ratio will be 10 times.
A low P/E Ratio can indicate a good value, but it can also indicate limited growth potential. A high P/E ratio is not always bad. In fact, it may indicate greater expected growth. Like dividend yield, P/E Ratio can also be trailing or forward. And it can be used to compare stock’s current value to its past or projected earnings. The benefit to P/E ratio is that enables you to determine whether a stock is trading at a premium or discount in comparison to similar companies.
Dividend Growth Investing
Dividend growth investing is a strategy focused on companies with a proven history of consistently increasing their dividend payments year after year. The primary goal is not necessarily a high starting yield, but rather a reliable and rising stream of passive income that can outpace inflation and compound wealth over time. Dividend growth companies were the primary criteria of the Dividend Aristocrats and Dividend Kings lists.
Dividend Growth Rate
Dividend Growth Rate is the percentage increase of the dividend payment during a certain period of time. It allows you to evaluate a company’s long-term profitability. It is calculated year-by-year, but the 5-year growth rate tells a better long-term picture.
The formula is (Current Dividend Divided by Previous Dividend) minus 1 Dividend by Years. To calculate DGR you will need data for two periods of time. For example, let’s say a company paid a $2.60 dividend in 2020 and in 2015, their dividend was $2.05. After dividing 2.60 by 2.05 and subtracting 1, you can see that the dividend grew a total of 26.8% over the 5 years. By dividing by 5, you get their annual dividend growth rate, which is 5.36%.
A growing dividend payment helps keep up with inflation and like DPR, it also demonstrates a commitment to paying dividends.
Dividend Payout Ratio
Dividend Payout Ratio (DPR) is the percentage of a corporation’s net income that is paid out in dividends. Investors like to analyze the dividend payout ratio because it provides a picture of how safe a company’s dividend is and how much room it has for future growth. It is calculated by dividing total dividends by net income.
The percentage of earnings that the company pays illustrates their commitment to paying dividends. However, an excessively high DPR can make continued growth risky and can be an indication that future dividend cuts are likely if earnings decline in the future.
Price-to-Earnings-to-Growth Ratio (PEG Ratio)
PEG Ratio takes P/E ratio a step further. It determines a stock’s value while also factoring in the company’s expected earnings growth over a period of time (typically 1-3 years). So, it provides a big picture look at the stock.
A lower PEG may indicate an undervalued stock and be useful when your goal is to find growth at a good price. PEG is calculated by dividing your P/E Ratio by the EPS growth rate.
Many investors desire a PEG Ratio less than 1. PEG is particularly useful when comparing companies in the same industry.
Reviewing Fundamental Data
Evaluating Dividend Health and Safety
Ratios offer you an efficient way to select stocks, analyze your portfolio, and manage your positions. However, ratios should not be evaluated in isolation. They are most useful when they are used to compare companies within a similar sector and industry. They are more effective when you view them in conjunction with other factors and ratios.