Return to:Previous Page
Morningstar.com's Interactive Classroom

Course 306
Dividend Yield

Introduction

 

Dividends aren't in the limelight these days, but they can still play an important supporting role. 

The surging stock market has been the star of the show in recent years, with investors applauding as their money has grown. All those capital gains make it easy to forget the other source of return from stocks: dividends. Dividends are the payments firms make directly to shareholders. And they can provide a source of stability in a stock portfolio, cushioning returns in a declining market. 

Dividend Yield Measures Dividends

 

The most common and useful way to look at dividends is in terms of dividend yield, which is equal to a company's annual dividend divided by its share price. For example, if Philip Morris MO sells for $34.50 per share and pays $1.68 in dividends, its dividend yield is $1.68 divided by $34.50, or about five percent. 

Dividend yield works as a kind of valuation measure: The lower the yield, the more investors have to pay for each dollar of dividends. Investors often consider stocks with high dividend yields potentially undervalued investments. 

Who Has High Dividend Yields--And Who Doesn't

 

Stocks with high dividend yields tend to belong to mature companies with few growth opportunities. Because the companies can't make much by investing profits in growth, they pay those profits back to their shareholders in the form of dividends. Utilities, with an average yield of 4.3% at the start of 2000, are classic dividend-paying stocks; as regulated monopolies, they have limited room to grow. Real-estate investment trusts, or REITs, also tend to have very high yields; by law, they have to pay out most of their profits to shareholders. 

On the other hand, rapidly growing companies, such as Microsoft MSFT and Intel INTC, generally pay few or no dividends. That's because they're reinvesting their cash flow into their businesses so they can continue to expand. In fact, 95% of technology companies don't pay any dividends at all. 

The Tale of Shrinking Dividend Yields

 

As of January 2000, the dividend yield of the S&P 500 stood at an all-time low of 1.14%. A little more than a decade ago, it was 4%. Why the drop? 

Stock prices have risen to the skies, but dividends have lagged behind as companies have found other uses for their extra cash. Many companies prefer to plow money into expansion, acquisitions, or share buybacks. That's fine with many investors, because dividends aren't tax-friendly: They count as ordinary income and are thus taxed at up to twice the rate of capital gains. 

High Dividends = Good Defense

 

But with dividend yields at an all-time low and other price multiples at all-time highs, prudence suggests taking a look at high-yield stocks. Not only do dividends help cushion the effect of any fall in price, but high-yielding stocks as a group tend to hold up better in bear markets than most other stocks. 

For example, the popular Dogs of the Dow approach, which involves buying the 10 highest-yielding stocks among the 30 Dow Industrials, performed best in the bear-market years of 1973, 1974, and 1977. Over the years, owning a few high-yielding stocks has proved a good way to diversify a portfolio. 

Not all high-yield stocks are defensive plays, though. A stock's yield may go up because its price has plummeted, often for legitimate reasons. (Remember, dividend yield is the dollar amount of the dividend divided by the stock's price.) A high dividend yield may also indicate that the market expects the company to cut or eliminate its dividend, leading dividend-oriented investors to sell off the stock and the stock price to fall. The best high-yielding stocks have strong cash flows, solid balance sheets, and relatively stable businesses. A history of steady dividend payments is also a good sign. 

When a company's fundamentals are solid, dividends can be a welcome bonus for shareholders and an indication of stability. They may be out of favor right now, but, like the hero's sidekick, sometimes they can save the day.

Quiz 306
There is only one correct answer to each question.

1 What are the two ways investors can make money from stocks?
a. Interest and dividends.
b. Special payouts and dividends.
c. Capital gains and dividends.
2 What does a falling dividend yield mean for a stock?
a. It means the stock is becoming more expensive.
b. It means the stock is becoming less expensive.
c. It has nothing to do with how expensive the stock is.
3 Companies with high dividend yields tend to be:
a. Fast-growing companies.
b. Mature companies.
c. Companies without much cash.
4 Which of the following is <em>not</em> a reason for the overall drop in dividend yields over the past decade?
a. Stock prices have risen.
b. Companies have chosen to invest more of their profits in their businesses rather than paying them out as dividends.
c. Earnings have fallen.
5 Which of the following is <em>not</em> a good sign in a company with a high dividend yield?
a. A solid balance sheet.
b. A history of paying regular dividends.
c. A sudden drop in the stock price.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page