The Motley Fool

What Is: The Dividend Yield

The valuation of a company is based on the money it earns for its owners. Simple enough, right?

If you were to sell your corner shop, for example, the price you’d get would be based on the profits it generates. And for a single-location corner shop, those profits would probably be expected to be stable over time and paid out to the owner of the shop.

The same is true with a quoted company on the stock market. If it is a company that is mature, has nowhere to realistically expand, and is paying out its profits as dividends, then, just as with our corner shop, it would be valued on the profits that the owner can take out of it. Put simply, the value in such a company would be based on its dividends.

In reality, it is possible to value all businesses in a similar way. The value of a company that is not paying a dividend can be seen as being ultimately dependent on its potential future dividends. The greater the profits it will make through expansion today and which it could pay out as dividends in the future, the greater the value of the company today.

And that’s true even if a company never plans on actually paying out any dividends, as it is the potential ability to pay out dividends that counts. Take, for example, Berkshire Hathaway, the investment company managed by the legendary Warren Buffett and Charlie Munger. Paying dividends is not part of Berkshire Hathaway’s strategy, but still the shares have spent decades growing in value.

The value of Berkshire Hathaway is related to the money it could pay out as dividends if it took all the growth in value of its underlying holdings each year and paid them out that way. So Berkshire Hathaway shares have a value and can be traded, even if none of the underlying investments are ever handed back to shareholders as cash.

Dividend yield
With a company that is paying dividends, we can use that dividend as an indicator of its value.

One handy number is a company’s dividend yield, which is simply a way of expressing its dividend as a percentage of its share price. If a company has a share price of 10 Euros, and it pays out a dividend of 0.5 Euros per share, its dividend yield will be 0.5/10, or 5%.

Dividend yield can be an especially valuable way of comparing investments in economic hard times when savings accounts are paying such low rates of interest. At such times, the value of a company’s dividends look especially tempting, providing we understand the difference in risk.

The risk associated with saving your money in a bank account that pays, say, 0.5% gross is very low. But the upside is that you know your capital is very safe.

If, however, you instead invest your money in a stock with the expectation of getting 5% the next time it pays a dividend, your risk is twofold. Firstly, the next dividend is not guaranteed, and a company can decide to pay out less (or even nothing) if it ends up not earning enough. Also, the value of your capital can fall if the company hits hard times and the market sours on its shares.

The trick to using dividend yield as an indicator of the value of a company is partly to see it as only one tool in our investing armoury and consider other valuation measures too, and partly to carefully consider whether a given company’s expected dividend is likely to be maintained.