Dividends and a roll of bills

Dividends are regular cash payments corporations make to shareholders as an incentive to get them to invest in the company. Dividend yield is a percentage figure calculated by dividing the total annual dividend payments, per share, by the current share price of the stock. From 2% to 6% is considered a good dividend yield, but a number of factors can influence whether a higher or lower payout suggests a stock is a good investment. A financial advisor can help you figure out if a certain dividend-paying stock is worth considering.

Some industries and securities are known for having high dividend yields. These include utilities, real estate investment trusts, telecommunications firms, healthcare businesses and energy companies.

Comparing Dividend Yields

One way to look at whether a dividend yield is a good one is to compare it to the dividend yield of the S&P 500. Many of these large blue-chip stocks pay dividends and their dividend yield is a useful benchmark for examining other companies’ dividend yields. As of this writing, in June 2021, the S&P dividend yield for the previous month was approximately 1.4%. However, that is unusually low. The historical S&P 500 yield is just under 2%, which suggests that any stock paying more than 2% is worth a look.

Another way to evaluate dividend yield is to compare it to the yield on U.S. Treasurys. Investors seeking income frequently invest in both government bonds and dividend-paying stocks, so comparing these two assets is one way to reveal an attractive dividend yield. In June 2021, U.S. Treasurys were paying 1.49%.

Finally, dividend yields can be compared among similar companies. Two companies of about the same size in the same industry will normally have similar dividend yields. If one is a lot higher, it may signify that it’s an attractive investment. However, high dividend yields can also be signs of trouble.

Causes of High Dividend Yields

Yield sign

A higher dividend is generally preferable to a lower one. And when a company is consistently raising its dividend in line with the profit increases fueled by its operations, that can be a sign of a dividend yield that will reliably produce income. But sometimes a very high dividend yield can indicate that a stock is not a prudent investment. That’s because the dividend yield depends not only on the dividend but also on the share price.

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If a company encounters challenging business conditions so that its stock price declines sharply while the dividend stays the same, the dividend yield may increase significantly. For instance, consider a stock trading at $100 and paying $1 per share quarterly. Adding up the quarterly dividends to get a total of $4 and dividing that by the share price of $100 produces a dividend yield of 4%. If the company reports a decline in earnings so that the stock price declines to $50, the dividend yield doubles to 8%, much higher than most dividend yields.

But in this case the very high dividend yield may be a warning, not an indicator of a wise investment. Exceptionally high dividend yields may be unattractive because, in addition to dividends, the return on a stock investment includes capital appreciation. And total return, including dividends and capital appreciation, is highly sensitive to stock price. If dividend yield is high because the company has fallen on hard times, it could signal further stock price decline. And if the stock declines even moderately, it can easily overcome the return-boosting effect of a high dividend, producing a negative total return for the investment.

Payout Ratio

Also, a company can pay out too much in dividends, so that it lacks enough cash to fund growth. One way to evaluate whether a company’s dividend is excessive is to look at the dividend payout ratio. This is calculated by dividing quarterly dividend per share by quarterly earnings per share and expressing the result as a percentage.

For instance, if a company earns $2 per share each quarter and pays out $1 per share each quarter, its payout ratio is $1 divided by $2 or 50%. If a company’s payout ratio is over 100%, that means it is paying out more than it is earning and that suggests the company may soon need to reduce the dividend to hang onto its cash. If profits decline and the dividend doesn’t, the company may need to borrow to keep the dividend up, which may not be sustainable in the long run.

Dividend yields above the 2% to 6% ideal range are not always a sign of impending trouble, however. Sometimes, dividend yields may be high because a company’s shares are undervalued. If research reveals the company’s fundamentals are strong, a higher-than-normal dividend yield can suggest the shares would be a good buy.

Bottom Line

Father and son put money in a piggy bank

If you’re considering dividend investing, dividend yield can help you determine whether stocks are good alternatives to other income-generating investments and also suggest insights into a company’s financial situation. Many factors, including the overall market, interest rates and the individual company’s financial situation, can influence dividend yields. But usually from 2% to 6% is considered a good dividend yield.

Tips on Investing

  • Accurately assessing a stock’s dividend yield and how it will fit in your financial plan calls for the assistance of an experienced and qualified financial advisor. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.

  • Knowledge is half the battle. Make sure you know what taxes you may have to pay on your investments with SmartAsset’s free capital gains calculator.

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