A high dividend yield is one of the most misread numbers available to a new investor, because it looks like a reward and is often a warning.
In short
- Yield is a fraction. It rises when payouts rise and when prices fall.
- Look at the payout in currency across several years, not the percentage today.
- Check whether profits and cash actually cover the payout.
- A yield far above everything around it is a question, not an opportunity.
A fraction has two halves
Yield is the annual payout divided by the current price. It rises when the payout rises. It also rises when the price falls, and it rises fastest when the price falls hardest.
So the same number describes a company paying more and a company the market has decided is worth less. On a screen they are indistinguishable.
The same number describes a company paying more and a company worth less.
How to tell them apart
- Look at the payout in currency, not as a percentage, across several years.
- Look at the share price over the same period.
- If the payout held steady while the price fell, the market is worried about something. Find out what.
- If the payout has been cut before, treat the current one as provisional.
| What you see | The good case | The warning case |
|---|---|---|
| Yield | Rising | Rising |
| Payout in currency | Growing year on year | Flat, or cut before |
| Share price | Rising more slowly than the payout | Falling |
| Covered by cash | Comfortably | Barely, or funded by borrowing |
Can they keep paying it
Compare the dividend to profit, and then to cash from operations. A payout comfortably covered by both is in a different position to one that exceeds either.
A dividend funded by borrowing or by selling assets is a dividend on borrowed time. Where to find these figures is covered in how to read an annual report.
Context beats the absolute number
Yields differ enormously between sectors and between markets. In an economy with high interest rates, ordinary yields are higher across the board, and a figure that looks generous elsewhere may be unremarkable there.
Compare a company to its own history and to its direct competitors. A yield that stands far above both is telling you something, and it is rarely that you found free money nobody else noticed.
The payout ratio, worked through
The payout ratio is the share of profit paid out as dividends. Take a company earning 2.00 a share and paying 1.20: its payout ratio is 60 percent, leaving 0.80 a share to reinvest or absorb a bad year.
Now let profit fall to 1.30 while the dividend stays at 1.20. The payout ratio jumps to about 92 percent. Nothing about the dividend changed, but its cushion almost disappeared, and if profit falls again the board has to choose between cutting it and borrowing to pay it.
One off payments inflate the number
A special dividend, paid once after a sale or an unusually strong year, is counted in the trailing yield for the following twelve months. A screen can show a striking yield that will not repeat. Check whether last year’s payments included anything labelled special or one time.
What it means for your income
If you hold shares for the income, the yield that matters is the one on the price you paid, and whether the payout in currency is growing. A modest yield on a payout that rises every year can overtake a high yield that is cut within two.
Common questions
Is a high dividend yield good?
Not by itself. Yield rises when the payout grows and also when the share price falls, so a very high yield is a question to investigate.
What is a payout ratio?
The share of profit paid out as dividends. Very high ratios leave little room if profits dip, which makes a cut more likely.
How do I know if a dividend is safe?
Check that both profit and cash from operations cover it comfortably across several years, and that it is not being funded by borrowing.
What is a special dividend?
A one off payment, often from a sale or an unusually good year. It can inflate the yield shown for a year without meaning it will repeat.