Dividend yield vs dividend growth

Dividend yield = annual dividend per share ÷ share price. A stock at $50 paying $2.00 a year yields 4%. It tells you today’s cash return on today’s price, nothing more.

Dividend growth is how fast the payment rises. Hypothetical: Stock A yields 5% and its dividend has not grown in years; Stock B yields 2% and raises its dividend about 10% a year. At those rates, B’s payment, measured against the price you paid, would pass A’s in roughly ten years, if that growth continued, which is never certain. Steady raises usually come from growing earnings; a dividend that never grows loses buying power to inflation. Peter Lynch’s “slow growers” are owned mainly for the dividend; see the Peter Lynch strategy.

Dividend Aristocrats
Members of the S&P 500 index that have raised their dividend for at least 25 consecutive years, tracked by S&P Dow Jones Indices in an index of the same name. A long record shows discipline; it does not prevent a future cut.

Payout ratio: can the company afford its dividend?

Payout ratio = dividends ÷ net income, or dividend per share ÷ EPS. In the drawing at the top, a company earning $4.00 a share and paying $1.60 has a 40% payout ratio: it keeps 60% of its profit to reinvest or to absorb a bad year. Above 100%, it pays out more than it earns, which cannot last unless profits recover.

What is normal depends on the business. Stable sectors such as utilities often pay out a larger share of profit than fast-growing companies, which need the cash to grow. Real estate investment trusts (REITs) are a special case: US rules require them to distribute most of their taxable income, so investors judge them on cash measures such as funds from operations (FFO) instead.

Free cash flow coverage: the cash test

Dividends are paid in cash, not in accounting profit, so check them against free cash flow too. FCF payout = dividends ÷ free cash flow. Hypothetical: a company pays $400 million in dividends and earns $1,000 million, a 40% payout ratio, but heavy capital spending leaves only $500 million of free cash flow, an 80% FCF payout. The dividend looks comfortable on profit and tight on cash.

When dividends exceed free cash flow for several years, the gap has to come from cash reserves, asset sales or new debt. Check the trend in FCF, the debt on the balance sheet, and whether buybacks compete for the same cash.

The high-yield trap: why a very high yield can be a warning

Yield moves opposite to price. In the drawing below, a hypothetical stock pays $2.00 a year: at $50 it yields 4%; after the price halves to $25, the same dividend shows an 8% yield. The yield went up because investors sold, often because they expect lower profits and a dividend cut.

Published yields usually use the dividends already paid, so they lag. If the company then cuts the dividend to $1.00 and the price slips to $20, the yield is 5% and the shareholder has lost 60% of the price, from $50 to $20. Before buying a yield far above its peers, check the payout ratio, FCF coverage, debt and earnings trend: it is often the value trap described in growth vs value stocks.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn seesaw under a fixed dividend of $2.00, labeled dividend unchanged: the price end sinks, from $50 to $25, while the yield end rises, from 4% to 8%; beside it, a three-row table of price, dividend and yield: $50, $2.00, 4%; $25, $2.00, 8%; and, in red above the words dividend cut, $20, $1.00, 5%; a highlighted note reads a high yield can mean the market expects a cut.

Reinvesting dividends with a DRIP

A dividend reinvestment plan (DRIP) uses each dividend to buy more shares, often fractional ones, through your broker or the company. More shares pay more dividends, which buy more shares, much like automatic dollar-cost averaging.

The drawing below is a simplified hypothetical: $10,000 in a stock yielding 4%, with the price and the dividend per share both unchanged for 20 years, before taxes and fees. Taking the dividends as cash, you would collect $8,000 and still hold $10,000 of stock: $18,000 in total. Reinvesting them, the holding grows about 4% a year to roughly $21,900, about $3,900 more, from dividends paid on reinvested dividends. Real prices and dividends rise and fall, so real results will differ.

Reinvesting suits money you do not need as income. It also keeps adding to the same stocks, so review your portfolio diversification from time to time.

Turn your phone sideways to read the drawing. Tap to close.

Hand-drawn stacked bars for years 0, 5, 10, 15 and 20 of a hypothetical $10,000 holding at a 4% yield: a gray hatched base for the original investment, a green layer for dividends received and a yellow top layer for dividends on dividends; totals read $10,000, $12,167, $14,802, $18,009 and $21,911, and a note reads hypothetical: 4% yield, flat price, before taxes.

Taxes, and a dividend stock checklist

Dividends are usually taxed. For non-US investors, US dividends are generally subject to a 30% US withholding tax, reduced if your country has a tax treaty with the US and your broker has your W-8BEN form; see how to buy US stocks, and check your own country’s rules. Investors who follow Sharia screens may also need to purify part of some dividends, as explained in halal stock investing. Before buying a dividend stock:

  • A yield in line with or modestly above its peers, not far above them.
  • A dividend that has grown over many years, backed by growing earnings.
  • A payout ratio that leaves room for a bad year, judged against its sector.
  • Free cash flow that covers the dividend, and debt that is not climbing to pay it.
  • Enough different companies and sectors that one cut does not sink your income.