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Dividend Yield
The Investor's Trusty Friend
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Perfect Your Dividend Strategy!
Dividend Yield - the investor’s trusty friend
Deep-Dive
INTRO
Dividend-bearing assets pay you on a regular basis no matter if the stock investment itself is on the upturn or in decline. Analyzing the dividend yield is key to perfecting your dividend strategy and more adequately evaluating investment opportunities.
If you're into stock investing, this term must sound like sweet music to your ears, like a promise of returns on your investment. But for those still wondering what it is, don’t worry. We'll break it all down together, and you’ll see that the dividend yield might just become your new favorite metric for evaluating the stocks you invest in.
What is it?
The dividend yield is a simple but powerful financial ratio. It’s calculated by dividing a company’s annual dividend per share by its current share price. In other words, it's the percentage you receive in dividends for every dollar or euro you invest in a stock. If a company pays a dividend of $2 per share and the share price is $40, then the dividend yield is 5%.
Not too shabby, right? It’s like asking yourself, "If I put my money into this stock, what kind of little annual (or quarterly) gift will I get in return?" That gift is the dividend, and the dividend yield tells you just how generous that gift is relative to what you paid for the stock.
The term “gift” may be a misnomer, but it's actually a share in the company's profits, which you've indirectly helped to create by choosing to invest your money in it to support its activity. It's a return on investment (ROI), in the same way that you receive rental income when you choose to invest in a rental property!
WHY SHOULD YOU CARE ABOUT DIVIDEND YIELD?
Now that you know what it is, you might be wondering why you should care. Here are a few reasons that should grab your attention. The dividend yield can give you an idea of how much a company likes to share its profits with its shareholders.
Some companies, like those in stable sectors (think utilities, food), tend to pay regular and high dividends. This can be a sign that the company is mature, with stable profits and less of a need to reinvest in growth. The most convincing examples are McDonald’s and Coca-Cola Company ($MCD and $KO), which have been distributing a portion of their profits non-stop for decades, with a rising dividend.
Below is the historical distribution level in euros per share for Coca-Cola and McDonald's for the last 5 years.
5-year trend of dividends per share for McDonald’s (MCD) and Coca-Cola (KO)
THE POTENTIAL PITFALLS
So who doesn’t love the idea of receiving a check from time to time without lifting a finger? That’s what dividends offer you—a passive income. For investors seeking regular returns, a good dividend yield can be a comforting source of income, especially in retirement.
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Even in volatile markets, dividends provide a cushion of security. In spite of share price fluctuations, as long as the company continues to pay dividends, you still have a positive return on your investment. Having a diversified portfolio of solid dividend stocks can be a real shield against crises and downturns in cyclical stocks, and protect the overall performance of your investments!
But like any good story, there are a few pitfalls to watch out for. A high yield can seem enticing, but it might also be hiding less pleasant surprises. A very high yield might indicate that the share price has dropped significantly. And if the share price is plummeting, it might be because the company is in trouble. In that case, the high dividend might not last long.
Imagine investing in a stock for its attractive dividend, only to see the company cut that dividend a few months later. It’s also essential to check if a company can maintain its dividend payments. The payout ratio (the percentage of profits distributed as dividends) is a good indicator. A payout ratio that’s too high might mean the company is paying out more in dividends than it’s making in profits, which isn’t sustainable in the long term.
Taking the same example with Coca-Cola and McDonald’s below, we see that our two flagship companies distribute a majority of their income, with McDonald's looking a little more cautious though with a relatively lower payout ratio. Distribution management is key for a company; it's all about keeping the right level of cash reserves, and not distributing everything to allow for ability to cope with any potential bad weather in the future!
HOW TO USE IT IN YOUR INVESTMENT STRATEGY?
Now that you understand the basics, let’s move on to how to use dividend yield to guide your investment decisions.
Some investors are true dividend hunters. Their goal is to build a portfolio of stocks offering high but also stable yields. This often means turning to solid, well-established companies in less volatile sectors. However, try to remember that diversifying your portfolio to some extent can still be crucial!
Beyond the current yield, it’s also important to look at the dividend’s history. A company that regularly increases its dividends is generally a sign of financial health and wise management. It’s like a double jackpot—a reasonable yield today, with the promise of an even better return tomorrow.
Dividend yield is also useful for comparing companies within the same sector. For example, if you’re torn between few companies in the oil and gas sector (like Total Energies, Shell, BP and Equinor historical dividend yields on the graph below), a quick glance at their dividend yields can help you see which offers the better return on investment in the form of dividends.
Now, to visualize the concept of dividends and for our own inspiration, let's take the example of one of the most popular dividend strategies; Warren Buffett and Coca-Cola!
The Oracle of Omaha famously exemplified the power of dividend yield through his investment in this stock. He bought the stock when it was yielding around 3%, and as Coca-Cola continued to increase its dividends year after year, Buffett's yield on his original investment grew substantially.
Now, he earns more in dividends each year from Coca-Cola than he originally invested in the stock. This is a classic example of how a solid, growing dividend yield can turn a good investment into a great one over time!
Additionally, thanks to the power of compounding, reinvesting your dividends—rather than cashing them out—can significantly boost your returns, which is another reason why understanding how dividend yield works is so important.
THE NUANCES ACROSS SECTORS
Not all sectors are created equal, and the same holds true when it comes to dividend yield. Understanding sector trends can help you calibrate your expectations.
Sectors like utilities, telecommunications, and consumer staples are known for their stable and often high dividend yields. These are sectors where growth is often slow but steady, and where companies prefer to reward their shareholders with generous dividends. On the other hand, tech companies and startups in fast-growing sectors tend to offer lower yields, or no dividends at all.
Why? Because they typically reinvest all (or most) of their profits into expanding their business. This isn’t a bad sign, but it means that if you’re investing in these sectors, you’re counting more on capital appreciation than on dividends for your gains. You’re banking on an increase in the share price rather than focusing on the passive dividend payout.
Some sectors, like energy or commodities as we saw earlier, can have volatile dividends. Their yield can be high when commodity prices are up, but may be reduced or suspended if prices drop. This is something to consider if you’re looking for stable dividends.
DIVIDEND YIELD IN A GLOBAL MARKET CONTEXT
So, what does dividend yield mean in a world where markets are increasingly interconnected and interest rates fluctuate?
Historically, when interest rates are low, dividend stocks become more attractive compared to bonds. Investors look for higher returns than what bonds can offer. But be careful—if interest rates rise, investors may turn to safer bonds, reducing demand for dividend stocks.
Globally, dividend yield also varies from country to country. Developed markets like the US and Europe tend to offer more stable and regular dividends. In contrast, in emerging markets, dividends can be higher but also more volatile, reflecting the rapid growth but also the increased risks in these economies.
Conclusion
The Dividend Yield can be a strong ally in your investment arsenal.
In the end, dividend yield is more than just a number. It’s a versatile tool that, when used wisely, can help you make informed investment decisions.
Whether you’re looking for regular income, wanting to gauge a company’s generosity towards its shareholders, or simply trying to compare investment opportunities, dividend yield is there to guide you.
But as with anything in finance, it needs to be used with discernment. A high yield isn’t always a good deal, and a low yield doesn’t necessarily mean a bad investment. It’s all about context, strategy, and your personal financial goals.
So, the next time you’re analyzing a stock, take a look at its dividend yield. And evaluate it over time - perhaps the last 3 to 5 years. It might just become your favorite indicator, helping you navigate the sometimes turbulent waters of the stock market with confidence. Happy hunting, and may your yields always be as high as your expectations!
Stay tuned for more investment insights to help you navigate the financial world with confidence and clarity!
Key Insight
A company that regularly increases its dividends is generally a sign of financial health and wise management.
Additionally, thanks to the power of compounding, reinvesting your dividends—rather than cashing them out—can significantly boost your returns
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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.
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