Dividend Yield Ratio

Dividend yield ratio is determined by the following mathematical formula: Dividend Yield Ratio = Dividend Per Share/Market Price Per Share. To simplify the expression, you can divide the dividend per share by the market price per share to arrive at the dividend yield ratio.

It is a financial metric that estimates the value of a share on the basis of dividends paid. It serves as a common measure for investors to assess the returns generated from investments. An important tool for comparing the dividends paid by a company with the prevailing market price, it provides insights on how well a company is rewarding its shareholders. An in-depth comprehension of what is dividend yield ratio is significant for investors to evaluate the return on investment for a particular stock.

Let us gain clarity on this important ratio by understanding the formula, calculation, examples, influencing factors, advantages, and potential drawbacks.

What is the meaning of the dividend yield ratio?

The dividend yield ratio provides a quick measure of the value of a particular stock in terms of the dividends received. It indicates how much cash flow you are receiving for the amount you have invested in a stock. The dividend yield ratio is also a general indicator of a company’s financial strength and its ability to generate regular cash flows. Moreover, only profit-making companies pay dividends, and therefore, a dividend yield ratio signals the stability of a company. If the result of the ratio is on the higher side, it indicates that the company is distributing a substantial share of profits to investors. On the contrary, a low dividend yield ratio suggests that a company is not returning a portion of the profits to investors due to reinvestment, sustained losses, heavy debt, contingency liability payouts, etc. The ratio is usually expressed by means of percentage.

Investors invest in stocks to maximise their wealth via two modes - capital gains and dividends. Capital appreciation can only be realised by an investor when he sells the stocks at a gain, whereas, dividends are paid by a company periodically and the payouts constitute a source of regular income. A common categorisation of investors is growth investors and value investors. Growth investors always invest in young companies in high-growth industries and expect returns through capital appreciation. However, value investors who prefer stable and regular returns invest in stocks having a high dividend yield ratio that offer regular returns through dividend payouts. Therefore, the dividend yield ratio meaning must be understood by a value investor and he should regularly employ this ratio as part of his toolkit while evaluating stocks.

Also read: What Is Dividend Yield Funds

Technical terminology of dividend yield ratio

Mathematically speaking, the dividend yield ratio is a ratio of the dividend per share and the current market value of the stock. It helps investors gauge whether a stock will provide regular returns on investment for the capital invested. However, there are further technicalities in the dividend yield ratio formula. The dividend per share in the numerator could either be gross dividends per share or net dividends per share based on which the ratio can be further classified into the gross dividend yield ratio and the net dividend yield ratio.

1. Gross dividend yield ratio

Gross dividends are determined by considering the dividend value before a company pays taxes on dividend distribution. The formula is given by:

Gross Dividend Yield Ratio = (Gross Dividend Per Share)/(Market Price of Share)

2. Net dividend yield ratio

Net dividends consider the actual cash received by investors and therefore includes taxes paid on the dividend payout. Its formula is given by:


Net Dividend Yield Ratio = (Net Dividend Per Share)/(Market Price of Share)

From the above formulae, it is clear that the net dividend yield ratio is a more conservative measure than the gross dividend yield ratio.

Formula for dividend yield ratio

The formula for dividend yield ratio is as follows:

Dividend Yield Ratio = (Dividend Per Share)/(Market Price of Share)

This formula suggests that the dividend yield ratio can be worked out by dividing the dividend per share by its market value. Usually, companies declare the total dividend as gross dividends before paying taxes. Therefore, the gross dividend needs to be divided by the common stock and then the result is further divided by the market price per share.

Also read: What Is Dividend Reinvestment Plan

How to calculate dividend yield ratio?

The calculation of dividend yield ratio is straightforward and is obtained by dividing the dividend per share by the market value of the stock. Dividend yield ratio suggests how investors view the growth prospects of a company in the future. As the market value of a stock is measured on a particular date, that price is not a true representation of the market value over the period of measurement.

A better way of determining market value per share is to consider the average or the median market value per share for the entire measurement period.

Example of calculation of dividend yield ratio

1. When all the terms in the formula are provided

Consider two companies XYZ Ltd. and RST Ltd. that both declare Rs. 20 as the dividend per share. However, the average market price during the period for XYZ Ltd. was Rs. 100 and that for RST Ltd. was Rs. 120. Find out the dividend yield ratio and provide a brief analysis of the numbers.

By the dividend yield ratio formula, the values for XYZ Ltd. and RST Ltd. are (⅕) and (⅙) respectively. In terms of percentages, these would be 20% and 16.67% respectively. It can be inferred that since the dividend yield ratio of XYZ Ltd. is higher than that of RST Ltd., a value investor seeking stable returns will prefer buying the stock of XYZ Ltd. The figure 20% indicates that if the stock is worth Rs. 100, the company returns Rs. 2 as dividend per share to investors.

2. When individual terms in the formula are not provided

DEF Ltd. has declared a dividend of Rs. 10,00,000 to be paid in this financial year. The number of common stock is 40,000. The average market price for the stock over the period is Rs. 130. Calculate the dividend yield ratio and interpret the results.

Here, the dividend per share is to be found out by first dividing the dividend by the number of outstanding shares. This value is (10,00,000/40,000) = Rs. 25 per share. Then, the dividend yield ratio is found out to be (25/130), which in percentage terms, would be 19.23%. This represents that for a market value of Rs. 100, the company pays Rs. 19.23 as dividend per share.

Also read: What is current ratio

Advantages of the dividend yield ratio

1. Cash flow analysis

Investors use the dividend yield ratio to gauge the cash flows they are generating on their investments. A hypothetical interpretation can be - for every Rs. 120 you invest in Company A per year, you receive Rs. 15 in the form of regular dividends.

2. Level of rewards

The dividend yield ratio is a good indicator of how much the company values its investors and rewards them through dividends. If a stable and profitable company has a very low dividend yield ratio, then it signifies that the company prefers to reinvest its earnings into core operations rather than rewarding its investors. Such a stock would be a bad choice for a value investor but a possible choice for a growth investor. This is because if a company pulls back its earnings into its core operations, it represents some form of business expansion, technology implementation, increased R&D expenditure, etc. all of which can result in higher capital gains.

3. Estimation tool

The historical figures provide investors a view on the future levels of the dividend yield ratio. A stock with a higher value of dividend yield ratio figure historically is more likely to maintain similar levels of dividend payouts in the future than a stock having a lower dividend yield ratio.

4. Identifying stocks

Investors, especially the ones who follow value investing, can identify fundamentally strong and profitable companies by using the dividend yield ratio. Such companies consistently maintain higher dividend payout levels and investors can choose such stocks as a less risky and more secure option.

5. Comparison tool

You can compare the returns on your investment with other investment alternatives such as mutual funds, fixed deposits, corporate bonds, government bonds, etc. by employing the dividend yield ratio.

Benefits of a low dividend yield ratio

Growth investors find a low dividend yield ratio to be extremely beneficial while considering stocks to be added to their portfolio.

• A low dividend yield ratio implies that a company is paying lesser dividends and reinvesting a majority of their profits into their core business operations for these activities - ramping up R&D, funding additional capital expenditure requirements, implementing a major upgrade for an existing product, developing a new product, and expanding into a new geography or a business segment.

• All these business activities help a company maximise gains over a long period of time which gets reflected in a substantial increase in its stock price. Growth investors, therefore, realise a higher capital appreciation for companies with a low dividend yield ratio than do value investors.

Also read: What is cash ratio

Benefits of high dividends for investors

• A high dividend level characterises a strong company in terms of consistently growing revenues, sustained profitability, and a positive cash flow. They are generally key players in their industry with lower borrowings and massive cash reserves.

• The difference between dividend yield ratio and returns from market indices represent the additional returns investors can generate by investing in a particular stock.

Factors affecting the dividend yield ratio

As the name suggests, the dividend yield ratio formula gives an idea about the consistent income an investor is likely to generate by investing in a company stock at the ongoing market price. There are several factors influencing the dividend yield ratio.

Price of the stock is the primary variable that affects the dividend yield ratio. A stock that is not trading at a premium cannot be expected to have a consistently high dividend yield ratio. The duration of stock holding is the second factor that impacts the dividend payments. A stock that is held for ten years is more likely to generate higher dividends than the same stock held for five years. As an investor, you should be aware of the power of compounding that takes place just because of a longer investment period. The third factor affecting dividend yield ratio is the company’s life cycle. A growing company will choose to reinvest profits into its business rather than paying dividends. This is in complete contrast to a mature company in a low-growth industry that will compensate its investors by paying higher dividends.

Also read: What is total expense ratio

Challenges with the dividend yield ratio

As is the case with any metric, the dividend yield ratio is not free from limitations. Investors should use this ratio along with other metrics for evaluating stocks. The first limitation is that a dividend yield ratio only provides information about the level of dividends paid with respect to the market value of a stock. In case of a lower value, it does not indicate how a company has reinvested profits. Therefore, growth investors should keep an eye on how the profits are utilised by a company. If a company is allocating its profits not towards its core operations but towards reducing liabilities, then it is a red flag.

A second point of concern is that the dividend yield ratio is calculated from the dividend per share in the numerator. That itself is obtained from the gross dividends, and therefore, the net dividends paid to investors is not accounted for. Also, it might happen that a company has paid Rs. 12 per share as dividend but declared a dividend of Rs. 14 per share in the same reporting period. Whether to include the dividend declared in the numerator does not have a straightforward answer. A third problem with the dividend yield ratio is that it will vary widely when there is economic volatility. The final reason why dividend yield ratio may not work is for companies that do not pay dividends at all.

Also read: What is Sortino Ratio

Conclusion

As an investor, you should look at dividend yield ratio as a metric to identify his return on investment for a company. It can serve as a point of differentiation between a growing company and a stable company. The ratio does not reflect a good or a bad company for investment. By utilising this ratio, you can get a sense of whether your return on investment will be primarily through capital gains or through dividends. Even though you will choose stocks considering the dividend yield ratio, you can always reduce the risk of investing in individual stocks by allocating some corpus towards mutual funds.

For investing in mutual funds, you can consider the Bajaj Finserv Mutual Fund Platform which is an interactive platform with a simplified user interface. From a list of 1000+ mutual funds, you can filter mutual funds based on category, market cap, theme, and industry, and subsequently, make a sensible investment decision. You can forecast your returns using the online free calculators and progress in your investment journey by learning from numerous educational videos. Start investing with Bajaj Finserv Mutual Fund Platform today!

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