Dividend investing is one of strategies used by many investors. There is however a concept that confuses some. So today I want to cover what exactly is dividend yield.
Many investors have come across and heard the phrase dividend yield however not everyone is comfortable with it or fully clear how it is calculated and what exactly it tells you.
Below I will break down this phrase and explain how it is calculated. I will also give some tips in terms of how to find good dividend stocks and which ones to potentially avoid. Sometimes a large dividend yields is actually a watch out rather than a signal to buy.
why investors like dividend stocks
Dividend investing is well known strategy. This strategy implies the investor to be primarily focused on buying stocks or ETFs that pay dividends to the person holding the asset.
When the right type of dividend stock is picked – this can deliver 2-5% annual dividends on top of share value appreciation. This can result in total annual returns in excess of 10%.
Dividend investing strategy is particularly interesting to those investors looking to live from a steady passive stream of income.
Dividend investing can form part of a retirement strategy. The investor would build up a large enough portfolio at first and use the income to offset his or her expenses.
The above would mean that the value of the underlying assets would not get eroded while the investor still be able to withdraw cash. On top of dividends the investor could expect their shares to appreciate over time.
A further benefit to dividend investing is dividend growth. This comes in the form of the company increasing its dividend cash payout over time.
A true life hack to the above is finding investments where dividend growth rate is at or above an average inflation rate. This would mean the investors annual payouts growing at above the average rate of growth of their expenses. This would actually allow the investor to improve their life quality as time passes.
what is dividend yield
So now to the important question – what actually is the dividend yield. In simple terms this is a metric of how much you are paid in the form of dividend in relation to the value of your investment.
As an example – let’s imagine you invest into a company that pays a 4% dividend. Their shares are worth £10 each. And at the time of purchase you have £1,000 to spend.
In the above example each share you purchase would pay you a dividend of £0.40. £1,000 investment would buy you 100 shares. This would result in a total dividend of £40.
As you probably already managed to calculate – £40 is exactly 4% of £1,000. And the best part of this – you will keep receiving the dividends for as long as you keep the shares. The only exception to this is in the case the company decides to cut its dividends.
In the ideal case scenario – the dividend yield will get increased over time and your actual cash payout will grow beyond the £40 you start your dividend journey with.
what if the dividend is paid more than once per year
This one is the scenario that gets people confused at times. Some companies pay their dividends 2 or even 4 times per year. And you might ask – does this mean in the above scenario with 4% dividend yield, you would receive £40 payment up to 4 times per year?
The answer unfortunately is a NO! If the total dividend you receive is 4% with 4 payments per year – the average payout will be £10. This will result in you receiving the exact same £40 per year however paid out more frequently and in smaller chunks.
The actual dividend payments also do not have to be split in equal amounts. A company might choose to pay a larger dividend at the end of its financial year compared to the other payouts.
what is a healthy dividend yield
When it comes to dividends – bigger doesn’t always mean better unfortunately. There are few things to check before investing.
Firstly, big dividends might signal that the payout is too high and unsustainable. This would be bad news for the investor looking to invest in order to secure themselves future income stream. It is always checking how big are the dividends in comparison to the total profits. Dividend cover has to leave enough profit for companies future income fluctuations.
Secondly, high dividend payouts might signal to the fact that there is no more income growth to expect from the company. This might be due to lack of growth in the industry or lack of investment into companies future product pipeline.
When it comes to the actual numbers – this will vary from industry to industry. You will however rarely find a dividend of more than 5% that is sustainable in the long run.
Some of the industries that offer higher dividends might be oil or tobacco linked businesses. These companies are operating in high margin industries. The risk here however is a declining interest and demand for their products.
One further point that you as an investor want to make sure – the dividends are increasing over the long run. This might be difficult for companies that already pay a high dividend yield when the demand for their products is decreasing.
summary
Dividend investing is a great strategy to build yourself a portfolio of assets that pay you passive income.
Before investing – make sure the dividends are well covered by the companies profits. This should also be increasing over long term. Ideally, the growth is also above the inflation rate.
There is a limit to how many dividends you can receive tax free in the UK each year. One way to avoid paying tax is to invest through your ISA account. These give you an opportunity to put £20,000 into your investments each year and all the income will be tax free for ever.