Dividend Yield Ratio – Formula, Meaning, Assumptions and Interpretation

Investors can be classified into types. The two predominant types are growth oriented investors and value oriented investors. Growth oriented investors invest in young growing companies. They expect returns in the form of capital appreciation backed by the high rate growth in the operations and profitability of the firm. On the other hand value investors invest in mature stable companies and expect returns in the form of stable cash flows paid in the form on dividends over and over again. The Dividend Yield ratio is meant for the second type of investors i.e. the value investors.

Formula

Dividend Yield = Annualized Dividend / Current Stock Price

Most companies pay dividends on a quarterly basis rather than on an annual basis. Hence for the purpose of finding out the dividend yield, analysts often annualize the dividend paid in the most recent quarter. They think it better projects the dividend paying ability of a company.

Meaning

Value investors often look at the stock of a company, the way a real estate investor looks at rental properties. They expect to put money one down one time and expect to receive payments for the rest of their lives. Hence the dividend yield tells them a percentage of their original investment that they would receive each year, if they invested in the stocks right away.

Assumptions

The dividend yield ratio assumes that the company in question will continue making dividend payments at the same or higher rate than it is currently doing. A historical analysis of the stock market will validate this assumption. Historically companies that have been making dividend payments continue to do so. This is because a dividend cut is adversely received by the market as a very negative signal and the share price immediately plummets. It is therefore reasonable to assume that the company will continue to pay dividends until something untoward happens.

Interpretation

The dividend yield company must be compared to competing investment options to get a better picture of the operations of the firm. It must also be applied to the company’s own historical records to validate the fact that it has indeed been making regular dividend payments.

• Stable Mature Companies: Dividend yield ratio is meaningful only when it is applied to stable mature companies. Companies in the field of utilities, hotels etc which have a regular and dependable cash flow are the ones in which dividend payout ratio is an important metric.

• Often Negligible: In advanced economy companies like IT, Electronics and communication, the dividend payout ratio is negligible. Investors look at these companies as engines of growth and not as avenues of stable cash flow.