By Joshua Kennon. Investing for Beginners Expert
Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.
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1. The Definition of Dividend Yield
When a company generates a profit, the board of directors often decides to mail out some of those earnings to the owners. For example, over the past 12 months, each share of McDonald's Corporation has generated $5.55 in after-tax profit, and the board decided to mail $3.24 per share out to the stockholders in cash. If you owned 100 shares, you received checks or direct deposits for $324. If you owned 100,000 shares, you received checks or direct deposits for $324,000.
That money that is mailed to the owners is called a dividend. The dividend yield is a financial calculation that tells you how much money you will earn for every dollar invested in the stock at today's price based on today's dividend rate.
2. How to Calculate Dividend Yield
To calculate the most common form of dividend yield, you take the per share cash dividend - keeping with our McDonald's example, it would be $3.24 - and divide it into the market price of the stock. This afternoon, shares of the cheeseburger empire closed at $94.07.
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Thus, to calculate the dividend yield we would take:
$3.24 cash dividend
--------- (divided by) ---------
$94.07 stock price
The answer is 0.0344, or 3.44%. This tells you that if you put $10,000 in McDonald's shares, you'd expect to collect $344 in dividends per year at the current rate. If you put $1,000,000 in McDonald's, you would expect to collect $34,400 in dividend income per year at the current rate. The 10-year Treasury bond yield, in contrast, is currently providing a return of 2.78%.
3. Dividend Yield on Market vs. Dividend Yield on Cost
The current dividend yield is only half the story. Unlike bond yields, which are based upon a bond paying a fixed rate of interest for the life of the bond, dividends for most successful companies increase over time. Let's continue using McDonald's as an illustrative case study. Take a
look at the dividend it distributed to owners for the past six years prior the time period we just discussed (2013):
- 2012 = $2.87 dividend
- 2011 = $2.53 dividend
- 2010 = $2.26 dividend
- 2009 = $2.05 dividend
- 2008 = $1.63 dividend
- 2007 = $1.50 dividend
If you had bought McDonald's stock back in 2007, you've watched your dividends increase each and every year. You're collecting far more than you originally anticipated based on the dividend yield on the purchase date. In fact, during that year, the stock averaged almost exactly $53 per share, so imagine you had bought a single share.
On the day you paid for your stock, you were collecting $1.50 in dividends on a $53.00 stock, which is a dividend yield of 2.83%. Yet, over the past 12 months, you've collected a dividend of $3.24. Comparing that $3.24 to the purchase price instead of the market price. you can calculate something known as "dividend yield on cost". In this case, you're actually earning the equivalent of 6.11% per year on your original investment. This can serve as a major driver of change in the stock price .
Companies that make their owners rich do so by continually earning more profit. Often, these businesses have some sort of inherent economic advantage, like the Coca-Colas of the world, which can raise prices or expand into new markets. The truly elite dividend payers on Wall Street, those businesses that have raised their dividend payouts to owners each year, without fail, for 25 years or longer, earn a title allowing them to be called a "Dividend Aristocrat". McDonald's has expressed a commitment to raising its dividend so much, in fact, that we are now approaching the 40th year in a row that it has sent bigger checks to the stockholders. That puts it in a league of its own among other blue chips on Wall Street. Only a handful of other firms can boast such a sterling achievement.
4. Some High Dividend Yields Are Traps
On the flip side of the equation are the dividend traps that ensnare inexperienced investors. These are companies that look like they are going to make you a lot of money by boasting extremely high dividend yields - often many times what the stock market as a whole is offering. Yet, sophisticated investors are not stupid. They are avoiding the business for a reason. Perhaps there is an enormous law suit that could bankrupt the company. Maybe the financials indicate the dividend is not sustainable and will have to be cut.
One defensive move in a situation like this is to look at the dividend yield of a company relative to others in the industry. If there is a single homebuilder offering a 14% dividend yield, something isn't right. Either they are in financial trouble, there was a one-time special dividend that won't be repeated, or there is some other factor that you will need to research; a stock quote alone won't suffice.