The dividend yield of a stock measures the amount of cash that owning a stock is expected to generate each year relative to the price of the stock. Knowing the dollar amount of dividends a stock pays is helpful, but without knowing the dividend yield, it’s hard to compare dividends. For example, a $5 dividend might sound better than a $3 dividend, but if the stock that pays the higher dividend cost $100 and the other stock only costs $20, the lower-priced stock has the higher-dividend yield.
If you know the dividend yield and the dividends paid, you can calculate the price of the stock. Alternatively, if you have a certain dividend yield that you need to obtain, you can calculate the maximum amount you’re willing to pay for a stock based on the dividends it pays out.
Calculating Stock Price from Dividend Yield
To calculate the price of a stock from its dividend yield, you also need to know how much it pays in dividends each year. Therefore, first, you need to add up all of the dividends the company paid during the prior year. Second, divide the annual dividends by the dividend yield to find the stock price. If you’re looking for a minimum dividend yield on your investments, the stock price you calculate is the maximum you can pay to obtain the desired dividend yield.
For example, say a stock pays quarterly dividends of 50 cents and you only want to invest if it pays a dividend of at least 4 percent. First, multiply 50 cents by four because it pays four dividends per year to find the total dividends per year are $2. Second, divide $2 by 0.05 to find the maximum stock price to have a dividend yield of at least 5 percent or $40. If the stock were over $40, the dividend yield would be less than 5 percent.
The Significance of Dividend Yield
The dividend yield is especially significant for investors looking to build a fixed income portfolio because it measures what percentage of your investment you can expect to get back each year. For example, if your portfolio has an average dividend yield of 4 percent, for every $1,000 invested, you can expect to earn $40 in dividends each year. Therefore, if you needed to earn $20,000 in dividends each year, you’d need to have a portfolio worth $500,000. If you could obtain a dividend yield of 5 percent, you would only need a $400,000 portfolio.
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