INSIGHTS

In this jargon buster, we explore the concept of a dividend yield, why it is a valuable measure for investors, and why a higher dividend yield is not necessarily better.

What is a dividend yield?

Dividends are the portion of a company’s profits that are paid out to shareholders. A dividend yield compares the annual dividends paid by a company to its share price. In its most commonly used form, it shows the percentage return an investor can expect to receive from dividends when investing in a company.

So if a company’s dividend per share for the year ahead is forecast to be $1, and you purchase shares in the company for $20 each, then the dividend yield would be 5%. That is to say, the return an investor can expect to receive from dividends alone is 5%.

Interpreting the dividend yield

The dividend yield informs an investor of the annual income they can expect to receive by way of dividends from their share investment. This makes for useful comparisons with the income from other investments, such as the interest rate on term deposits, or the rental yield on a property.

Of course, the other key component of the return from shares is the change in the value of the shares themselves, which tends to be more volatile.

It is also important to note that as dividend yields are usually based on expected dividends, the actual dividend received may turn out to be greater or smaller than anticipated, depending on how the company actually performs. Don’t underestimate the importance of dividends

Dividends are, of course, an important contributor to returns. From January 2000 to December 2022, the NZSE capital index (this excludes dividends) has returned 3.6% per annum. Meanwhile, the NZSE gross index (which includes dividends that are then reinvested in the index) has returned 8.8% per annum. This clearly shows that dividends have historically made up a significant portion of returns from New Zealand shares, while also providing a valuable source of income.

Bigger is not always better

Does this mean, therefore, that we should then just invest in companies with the highest dividend yield? Not necessarily:

A company with a high dividend yield is likely to be paying out close to, or all, of its profits to shareholders. While not necessarily a bad thing (especially for companies operating in mature industries with limited investment opportunities), this means the business has fewer funds available to reinvest into growing the business, thereby driving future dividend growth and shareholder returns.

A high dividend yield could also be a sign that the market sees a reasonable chance that a company’s dividend is unsustainable and may need to be cut. This may be due to the company paying more in dividends than it earns, or because the operating environment is deteriorating.

When we look at companies, we focus less on the current dividend yield, and more on the company’s ability to sustainably pay and grow its dividend. This includes looking at the strength of the company’s cash flow (from which dividends are ultimately paid), along with the outlook for the company and the structure of the market in which it operates.