Stock Investment Dividend Yield Pros and Cons With a Formula

By Indeed Editorial Team

Published June 10, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Investors can use their dividend yield to value a company's dividend payouts to shareholders. Other factors, such as market conditions, share price fluctuations, and a company's financial health, can affect the validity of using dividend yield as an evaluation method. Understanding the advantages and limitations of dividend yield can help determine how a company appears to outside investors. In this article, we discuss the dividend yield pros and cons, explain how dividends work, list the various types, and explore why dividend yield is important.

The importance of considering dividend yield pros and cons

Dividend yield pros and cons can help potential shareholders determine whether to invest in a company. A dividend yield is a tool that investors can use to calculate the return on investment they receive as dividends from a company according to the stock's current market value. Dividends are periodic payments that a company makes to shareholders. It's a percentage of the company's profits that serves as an incentive for investing in the company. Although companies typically pay out dividends quarterly, some may decide to pay their investors monthly, semi-annually, or annually.

Investors who use dividends as a form of income usually look for high-yield stocks to secure a stable cash flow. High and low yields can have various meanings depending on multiple market factors, including the company's industry, stock prices, and financial outlook. For example, a company with a high dividend yield may look suitable to investors, but it may also be a sign that it has financial challenges. A low dividend yield may show that a company is focusing on its growth and reinvestment, which may be an ideal long-term investment option.

Related: What Is a Shareholder? (With Responsibilities and Types)

How do dividends work?

When a company pays dividends to shareholders, it typically distributes the dividends relative to the number of shares the investors own. This is standard practice, but there are situations when a company changes its dividend allocation. Here are some of these situations:

  • Regular dividends: This refers to the most common type of dividend, where a company consistently pays a set amount to ensure it remains viable in favourable and less than ideal circumstances. Consistently making regular dividend payments can increase a company's appeal to investors.

  • Special dividends: This is a one-time dividend payment a company may decide to pay after consistent highly profitable quarters or because it sold an asset and isn't planning to use the funds immediately. Companies pay special dividends because they gradually accumulate cash that isn't necessary for operations.

  • Variable dividends: Companies producing commodities such as timber, oil and gas, and mining materials sometimes decide to pay variable dividends in addition to regular dividend payments. Although they pay variable dividends at consistent intervals, the amount varies depending on their earnings during the prior quarter or year.

  • Preferred dividends: When a company decides not to allocate dividends to all shareholders or is unable to, it may choose a preferred dividend. Only shareholders with preferred shares in a company can receive the benefits, resulting in a small outlay to cover the dividends.

Related: What Are Business Quarters? (With Definition and FAQs)

Types of dividends

Dividends enable a company to share profits with shareholders. Since investors typically find companies that regularly pay valuable dividends appealing, many organizations prioritize meeting their dividend goals to keep their valuations high. The following are the most common types of dividends:

Cash

Cash dividends refer to the distribution of cash to shareholders as a return on their investment. Shareholders can choose to reinvest their dividends to increase their investment. Although companies that pay dividends typically have a strong cash flow, dividend payments can also restrict business growth if a financial challenge arises due to a fund shortage. These companies also have dividend policies that can alter the amount of the dividends they pay to shareholders in specific situations, such as significant recoveries from litigation, unusual profit earnings, or excess cash in the financial system.

Related: What Is Cash Flow? Definition, Types, Template, and Example

Stock

Companies can issue stock dividends to shareholders instead of cash. This happens when they may not have the resources to pay cash dividends. A company can pay stock dividends when it intends to provide a return to the shareholders. Once a company releases a stock dividend, the number of available shares increases by a certain percentage. For example, if it awards a 5% stock dividend, it issues one share against every 20 company shares. This means that an investor with 100 shares can get five shares, but the value of the new and old shares stays the same.

Related: Guide: How To Become a Stockbroker

Property

Property dividends refer to the distribution of property to shareholders as a return on investment. A company calculates the market value for property dividends and records the dividend on the acceptable value. For example, when a company buys a property for $100,000, and its current value is $150,000, it records an investment gain of $50,000. This means the accounting department records the property's value as $150,000, which they treat as the actual value of the property dividend.

Liquidation

A liquidating dividend occurs when a company distributes assets among shareholders by paying them a dividend. It can be a partial or complete liquidation, which means the company may choose to sell some or all its assets. It's important to remember that company shareholders don't receive dividends immediately. A company first pays its creditors before distributing the remaining funds among shareholders.

Why dividend yield is important

When a company pays dividends to shareholders, it can be a good sign of financial success. Dividends are commonly cash payments that the company gives shareholders from its earnings. The dividends that shareholders receive an increase as the company's yearly income rises. A high dividend can signify that the company is doing well and provide current investors and potential stockholders insight into its performance and prospects. Investors may be more likely to invest in a thriving company.

Dividend yield formula

Investors can calculate a company's dividend yield by reviewing its recent annual financial report. They typically wait a few months after a company releases its annual report. If an investor waits too long, the information in this report can become less accurate. Here's the formula investors typically use to calculate a company's dividend yield:

Dividend yield = (Annual dividends per share / Market value per share) x 100

  • Annual dividends per share: This refers to a company's annual dividend payment, divided by the number of outstanding shares.

  • Market value per share: This denotes a company's current share price.

Related: How to Calculate Current Yield (Formula and Examples)

Dividend yield pros and cons

A company's dividend yield can help potential shareholders decide whether to invest. To better understand dividend yield, it's important to learn about its advantages and disadvantages. The following are the pros and cons of dividend yield:

The advantages of dividend yield

Investors can use a company's dividend yield to determine if it can continue to pay shareholders using the money it earns from revenues. They can consider the yield when deciding where to invest their money. This is significantly important for investors who live from their investment portfolio since it shows whether the stocks they're considering buying can produce enough income.

Researching dividend yield is the first step for some potential investors before looking at the cash flow and other company operations. The yield is also helpful for evaluation. Differences in current and historical dividend yield amounts show investors that a certain stock is trading at a better or worse value.

The disadvantages of dividend yield

A significant disadvantage of dividend yield is that investors may use it as the only indicator of a stock's potential. For example, an investor may find a high dividend yield attractive but not consider other challenges that the company may encounter during the next few months or years. To prevent a less than ideal investment outcome, investors can carefully consider additional indicators regarding a company's operations. Here are additional factors to consider when making an investment decision:

  • Financial strength: Investors can assess a company's financial stability by considering its cash flow and working capital. A successful company can cover all its expenses when it experiences sudden challenges.

  • Dividend growth: Dividend growth shows investors whether a company is successful and can increase its earnings and dividend payments to shareholders. For example, if a company has a long history of rising dividends, it's likely to continue this trend.

  • Competitive advantages: When making an investment decision, an investor can consider the relationship between a company and its competitors. For example, a company can offer more innovative products and services.

  • Growth prospects: Measuring a company's growth prospects involves analyzing the relevant industry. Popular industries typically provide better growth opportunities.


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