There are two ways to make money when buying a stock--capital gains (when a stock goes up in price) and dividend payments. Dividends are payments that companies make directly to shareholders.
Dividend yield has been an important measure of valuation for many years. The dividend yield is equal to a company's annual dividend per share divided by its stock price per share. So, if a company pays an annual dividend of $2.00 and has a stock that trades for $100, its dividend yield is 2.0%. If that same stock's price fell to $50 per share, its dividend yield would rise to 4.0%. Conversely, all else equal, the dividend yield falls when a stock's price goes up.
Dividend Yield = (Annual Dividends Per Share) / (Stock Price)
Stocks with high dividend yields are generally mature companies with few growth opportunities. The economic reasoning behind this is that these companies can't find enough promising projects to invest in for future growth, so they pay a larger portion of profits back to shareholders. While utility companies are considered the typical dividend-paying stocks, you can also find dividends in sectors with lots of room left for growth such as the pharmaceutical industry.
Dividends have recently begun to garner investors' attention again. A big driver of this new focus was a recent change in the United States tax code that lowered the tax rate on dividends. So if you are looking for dividend income from your stock investments, remember that the best high-yielding stocks have strong cash flows, healthy balance sheets, and relatively stable businesses. And, if you're relying on that stream of dividends for income, checking for a steady history of dividend payments is also a good idea.
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