Dividend yield is one of the first numbers many investors look at when they want income from shares. It tells you how much a company pays out in dividends each year relative to its share price. Simple as it sounds, it is also one of the easiest figures to misread, and a high yield is not always the bargain it appears.
The basic calculation
Dividend yield is the annual dividend per share divided by the current share price, shown as a percentage. If a share costs £10 and the company pays 50p a year in dividends, the yield is 5%. In plain terms, if the dividend stayed the same and the share price did not move, you would receive 5% of your investment back as cash each year.
Most data providers use either the dividends paid over the past twelve months, known as the trailing yield, or the dividends analysts expect over the next twelve months, known as the forward yield. It is worth checking which one you are looking at.
Why yield moves with the share price
Because the share price is in the calculation, the yield changes every time the price moves. If the share price falls and the dividend stays the same, the yield rises. If the price rises, the yield falls.
That is the key to understanding why a high yield can be a warning sign. A yield often looks unusually attractive because the share price has dropped sharply, and the share price has often dropped because investors expect trouble, including the possibility that the dividend will be cut.
The yield trap
This is known as a yield trap. An investor buys a share because the yield looks generous, only for the company to reduce or suspend its dividend. The income disappears and the share price often falls further. The headline yield was based on a payment that was never going to be repeated.
To avoid this, look at dividend cover, which compares profits with dividends. A company that earns comfortably more than it pays out has room to keep paying even if profits dip. One that is paying out more than it earns may be relying on borrowing or reserves, which cannot last. Free cash flow, the cash left after running the business and investing in it, is an even better guide, since dividends are paid in cash, not accounting profit.
Dates that matter
Dividends come with a timetable. The ex-dividend date is the key one for traders. If you buy a share on or after that date, you will not receive the next dividend. On the ex-dividend date the share price usually drops by roughly the value of the dividend, because new buyers are no longer entitled to it. That is why buying a share just before it goes ex-dividend is not a free lunch.
If you trade shares through CFDs or spread bets, dividend adjustments are applied to your account instead: long positions usually receive an adjustment and short positions pay one.
Yield in the wider market
Dividend yields are often compared with bond yields. When government bond yields are low, dividend-paying shares can look attractive by comparison. When bond yields rise, as they have done recently, investors can earn a competitive return from safer assets, which can reduce the appeal of shares bought mainly for income. Our guide to how bond yields affect stocks and forex explains that relationship.
The UK market has a reputation for income because many large companies in the FTSE 100, such as banks, energy groups and miners, pay significant dividends. US technology giants, by contrast, often pay small dividends or none, preferring to reinvest or buy back shares. Our explainer on share buybacks covers that alternative way of returning cash.
Using yield sensibly
Dividend yield is best treated as a starting point. A sensible yield backed by solid cover, healthy cash flow and a manageable debt load is very different from a high yield on a struggling business. Look at the history of payments, the company’s stated dividend policy and how sensitive its profits are to the economy.
It is also worth remembering that dividends are never guaranteed. Companies can and do cut them when conditions change.
If you would like to understand where income investing and active trading fit for you, our free trader assessment is a useful first step and highlights what to focus on next.
