Dividends are cash payments paid out from a company to its shareholders, typically on a quarterly or semi-annual basis. The dollar amount per share of dividends received in a year, divided by the price of the stock, is referred to as the dividend “yield”.
The rate of dividend growth – how often and how much the dividend is raised by the company from year to year - is also an important consideration to many traders.
Components of dividend yield and historical rate of dividend growth
If a stock is trading at $20 a share and the company pays $1 in dividends over the course of the year then the dividend yield is 5% ($1 dividend / $20 stock price). If the same stock paid a dividend of a $1 and was trading at $40 a share, then the dividend yield would be only 2.5% ($1 dividend / $40 stock price)If the annual dividend that the company paid a year ago was $0.80, then the dividend growth is $.020, giving a dividend growth rate for this year of 25% ($0.20/ $0.80).
What traders look for
Dividends represent a source of cash income (sometimes additional stock in place of cash if issued as a stock dividend) from a stock investment. It is important to note that when a dividend is paid, it is paid directly from the company that an investor owns, thus reducing the value of the owned company. For instance, if a company’s equity is worth $20 per share and they pay a $1 per share dividend, the company’s equity is now worth, in theory, $19. Companies in their growth stage often forego paying a dividend, instead choosing to reinvest any cash they earn back into their business. However, traders seeking current income and a potential long-term tax benefit may prefer shares of stock that pay a meaningful dividend. This creates a certain amount of built-in demand for dividend-paying stocks, particularly higher yielding stocks.
The rate of dividend growth – how often and how much the dividend is raised by the company from year to year - is also important to many traders. Typically companies that consistently raise the dividend that they pay per share create a source of consistent value that many traders seek.
As with many other value factors, it is useful to compare a stock’s current dividend yield to its own historical range of dividend yields in the past, and to the average dividend yield of all stocks to assess the relative value of the current dividend yield.
What traders look out for
While a high dividend yield is typically thought of as a positive sign, there may be times when it can be a warning sign. A historically high dividend yield for a particular stock may signal that it is presently an exceptional value; however it is possible that a company with a historically high dividend yield may instead be in financial trouble and may have trouble maintaining its dividend. This financial trouble will often be reflected by a lower stock price, which serves to raise the current dividend yield. So it is always useful to examine the financial strength of a company before buying its stock on the basis of a high dividend yield.
If a company is not earning enough to cover its dividend payments it may be able to continue paying out from the company’s available cash on hand. But if business operations do not improve eventually the company may need to cut the dividend. A dividend cut can serve to sour investors on a particular company for an extended period of time.
Dividend yield and growth are secondary factors that often help to illustrate that a company is healthy and anticipates having a long-term supply of available cash. For many traders the opportunity to generate income from a company or sector that is typically considered to be growth-oriented can be very enticing. Nevertheless, traders should remember that money paid out in dividends is money that the company can no longer reinvest to grow the company. Still, many value-oriented traders look for stocks with a meaningful dividend yield and whenever possible, those with a strong history of steadily increasing dividend payouts.