The Curious Investor

Yield is a term that is come across often in investing. It can refer to a plethora of things. The most noteworthy of the yield appellations is the yield curve which refers to the tracking of effective rates of interest (yields) for US Treasury bills and bonds of various lengths - short term and long term. When talking about stocks, yield refers to a similar “interest” or rate of return on your investment in a stock.

A stock with a guaranteed rate of return? No, it’s not some kind of miracle investment. The rate of return refers to the dividend paid by a company to its shareholders. Dividend is a portion of a company’s earnings which is distributed to its shareholders each year as decided by the company’s board of directors. It is usually quoted in dollar amount per share and the yield refers to this value divided by the current price of a stock. As such, when differentiating between bond yields and yield as it relates to stocks - one could use the term dividend yield.

So, why is dividend important? Well, for the most part, the only companies which offer dividends are secure and stable ones. Smaller, high-growth companies will usually make a decision not to offer dividends, but instead to re-invest earnings into the company to help sustain growth. In a way, you could look at dividends as a way to equalize the potential return on a more established business. Since big, stable companies tend to have stock’s whose prices do not move as much, the prospect of knowing you will definitely make a return through dividends is meant as an attempt to make an investment in these companies more attractive.

I personally don’t find dividend paying stocks to be the be all and end all of my stock search and thus, unlike P/E ratio, yield is not necessarily an important factor in my valuation. That being said, dividend paying stocks can serve as a valuable member of your investment portfolio. In uncertain or poor economic climates, it is always nice to have an investment which you know will pay you a return. Further, as said earlier, in all likeliness picking a stock which pays dividend means you are picking a strong, stable company which you don’t have to be afraid to hold long term. This is not just mere conjecture. Various studies have shown that dividend paying stocks in the have historically outperformed non-dividend paying stocks and also been historically less volatile. (some numbers can be found in this report by Allianz Global)

Investing based on yield can be a very good strategy for people with a long term focus who want more flexibility than CDs or Bonds but with equal or better rates of return. Creating a dividend/yield rate based portfolio can allow you to have a portfolio which generates a reliable source of annual return while also the potential for good growth in the initial seed investment. It does come at a higher risk than a CD or bond, but with the stability of most dividend paying companies, the investments, if picked correctly, should never suffer the type of volatility that scares most people away from stocks. Further, new tax law has made return from dividend taxed at only 15% versus the normal income tax on CD or money market interest returns. On the downside, the dividend/yield rate strategy also means that often times you will not be investing in the “sexier” stocks and, for the most part, will never find a tell-all-your-friends-at-dinner kind of stock pick that will make you 200% in a month.

Yield can be used several ways. First, in the creation of your dividend stock portfolio, you can aggregate yield numbers to calculate your expected yearly return and use this number to augment the expected returns based of the stock you are investing in and help you make a decision as to whether or not the stock’s value, volatility, and growth potential suit your portfolio. Also, yield rates can serve as a red flag for potentially bad companies. In general, you want to find yield rates above 4.5% (any lower and the investment is not much better than a CD and then you should focus on the actual return of the stock’s price changes as opposed to the dividend) but not in the upper stratosphere of yield rates (do a quick stock screen to see). The most important thing in finding dividend paying stocks is finding those that will pay consistent, sustainable dividends. Yield rates which are very high usually signal an unsustainable dividend or, worse yet, a desperate corporation trying to woo investors with its high dividends. Remember, don’t use yield alone to build a portfolio as dividends are not guaranteed and can be changed by the corporation at any time. These changes can also have a significant impact on a stock’s price as well so it is always a good policy to make sure that the dividend stock you are choosing is that of a strong company with at least moderate growth. After all, the most important return ultimately is not your return from dividends but from the buying and eventual selling of your stock.

If you are interested in learning more about dividend investing and how to find winning dividend paying stocks, check out these articles: Dividend Paying Stocks Guide from WinningInvesting.com and 6 Secrets to Finding Dividend “Money Machines” from Motley Fool.

Bookmark to: