The dividend yield ratio tells investors how much cash income they’re receiving on their stock investment in a business. You can compare the dividend yield with the interest rate on high-grade debt securities that pay interest.
In the business example shown in the following figure, suppose that the business paid $1.50 cash dividends per share over the last year, which is less than half of its EPS. (The ratio of annual dividends per share divided by annual EPS is called the payout ratio. )
You calculate the dividend yield ratio for the business as follows:
$1.50 annual cash dividend per share ÷ $70 current market price of stock = 2.1% dividend yield
An income statement example for a business.
The average interest rate of high-grade debt securities (U.S. Treasury bonds and Treasury notes being the safest) is sometimes two or more times the dividend yields on
public corporations. In theory, market price appreciation of the stock shares makes up for this gap. Of course, stockholders take the risk that the market value will not increase enough to make their total return on investment rate higher than a benchmark interest rate.
Assume that long-term U.S. Treasury bonds are paying 4.5 percent annual interest, which is 2.4 percent higher than the business’s 2.1 percent dividend yield in the example. If this business’s stock shares don’t increase in value by at least 2.4 percent over the year, its investors would have been better off investing in the debt securities instead.
Of course, the investors wouldn’t have gotten all the perks of a stock investment, like those heartfelt letters from the president and those glossy financial reports. The market price of publicly traded debt securities can fall or rise, so things get a little tricky in this sort of investment analysis.