Explaining Dividend Yield

By Chris Blanchet

 

For many investors, earning income used to be an easy and simple process. You would invest $100,000 on, say January 1 and over the next five years you would earn a steady 8% on that investment. At maturity, you would get your $100,000 back and you would have renegotiate your term deposit rates with your banker. Over the years, the process became marginally more complicated. Rates on term deposits dropped, allowing fewer people to enjoy the lifestyle they had become accustomed to. And so the choice of investment changed as well. Instead of term deposits, investors might have shifted into fairly safe government or corporate bonds. For a slightly higher rate, investors needed to take on a little higher risk. And while bond prices would fluctuate between the day you bought and the day the investment matured, at the maturity date the face value of that bond was repaid to the investor. It was all good.

But as many people know quite well these days, fixed income investments like bonds come with considerably more risk. In periods of increasing rates, those bond prices will drop. And while the face value will be repaid at maturity, there is always the "what if" of needing the investment prior to that maturity date. With liquidity such a big concern for a lot of investors, they have had to look elsewhere. And of course, to add salt to the wound, rates are just not as attractive as they used to be.

This is how dividend paying securities have gained a lot of traction recently. With the expected rate increases in the near future as well a need for liquidity thanks to the current economic state, dividend paying stocks have meant a return to higher income while taking on only marginally greater risk.

Companies like General Electric, most of the big Energy companies, many solid banks both domestic and international, as well as many other blue chip companies will pay income in the form of dividends. This income, as a percentage of the price of the security, is what is known as the dividend yield.

The dividend yield on any given security will fluctuate each time the security trades at a new price. For example, a $3.00 dividend on a $50 stock is a 6% yield; but once that stock goes to $75, that yield drops to 4.5%. In other words, as the security price increases, the yield drops. This is exactly how things work with bonds. And like bonds, the income stream to the investor remains the same.

For example, an investor who bought at $50 will control the same amount of shares regardless of what happens to price. As well, the income will always be 6% of their investment. If they invest $100,000, the income will always be $6,000, even when the security price rises to $75 and the yield drops to 4.5%. So when the stock price increases, the <i>value of the investment</i> will increase on paper. The income remains the same at $6,000.

Essentially, dividend yield matters only when the original investment is made. As the security price increases, the yield will drop, but the investor's income in dollar terms remains the same. The biggest difference with stocks versus bonds is that the investor will have a little more pressure to sell at market prices. But the problem will be how to replace the original income.

So while dividend yield only matters when making the original purchase, comparing one dividend for one stock to another dividend on another stock whenever a change is made in one's portfolio becomes an ongoing concern. And investors needs to stay abreast of these yields, rising or otherwise, so that they know what the "going" rates are.

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Chris has more than 17 years of financial services experience. He currently manages a website about Roll Roofing [http://www.roll-roofing.com/] at Roll-Roofing.com where he discusses different roll roofing alternatives.

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