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Decoding the Dividend
Yield Formula
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Published:
September 22, 2008
The
Pythagorean Theorem isn't going to make you any money. Nor the
quadratic equation. But there is a financial formula -- an
immutable law of investing -- that can help you choose stocks that
will pay a double-digit yield for as long as you own them.
In our "Feature Topic" we'll
help you profit using this fundamental investing principle -- which
works in any market, up or down. We'll also show you how to use this
tool to juice your portfolio's returns with rich dividend streams
-- double-digit payouts you otherwise wouldn't be able to obtain.
It's not complicated or esoteric.
But it's still a bit of investing
minutia that people tend to overlook
or just get wrong:
A stock's yield is calculated by
dividing the per-share dividend by
the purchase price, not the market
price.
Price and yield move in opposite
directions. As stock prices rise,
dividend yields go down. As stock
prices fall, dividend yields rise.
Let's look at an example: A
fictitious stock trades for $100 a
share and pays a $5 dividend. You don't even
need a calculator to determine its
yield: It's 5%.
Conventional thinking is that if the
price of this mythical company
rises, say to $200, then its
dividend yield will fall. And indeed
it will -- it will be cut in half.
$5 / $200 = 2.5%. But that only
applies to investors who bought the
shares at the new price. The
investor who bought at $100 is still
earning a 5% yield.
But here's where things get
interesting -- and profitable. If
the share price moves in the other
direction, down, and it drops to
$50, then the dividend yield will
rise: $5 / $50 = 10%.
Once again, though, that's only true
for the investors who bought their
shares for $50. The investors who
bought at $100 are still earning
their 5%. For most investors, yields
do not "change," they're only
"established." And their stocks keep
paying that yield unless the
company's actual dividend payout
changes.
Yield has nothing to do with the
current market price -- only the
current dividend, and the price you
paid for your shares. If you bought
your shares at $100, a $5 dividend
earns you 5% no matter what happens
to the share price, again assuming
the dividend remains constant.
That's why a bear market presents an
immediate opportunity for investors
seeking significant dividend income.
Most stocks are deep into the red:
Here at home the S&P 500 Index is
down -20.% for the past 12 months,
with most world indexes similarly in
the red. Stocks in China are off
-64.9%. These depressed prices mean
dramatically higher yields. When a
market falls -50%, its yields double.
And here's the kicker: When you buy
a stock with a depressed price and a
high yield, you lock in that outsized
yield, just as if you'd put your
money into a CD and locked in the
interest rate.
Remember: Buying a stock just for
the dividend alone is a bad idea.
Dividends are never guaranteed. And
a high yield isn't always a good
thing -- some of these companies
could be worthless tomorrow, like
Freddie. You want the same traits in
a dividend payer as you would in any
other company you're considering: A
solid financial footing and a strong
history of rising profits and
dividend increases.
No serious income investor should
wait to lock in such rich income
streams. You can't afford to sit on
the sidelines. Bear-market buying
opportunities just don't come around
very often. Most of the time, of
course, that's a good thing. But
since a down market is already here,
you might as well profit from it by
locking in these extraordinarily
high yields.
You see, no company -- or very, very
few -- set out to pay a 10%-plus
yield. That's a healthy yield no
matter where you go. In this
country, a 5% dividend stream is
above average, even robust. But in a
down market, even a 5% yield can
rise dramatically, purely because
stock prices are falling. That's the
power of the dividend yield formula.
Take a look at our table. It
shows what various price drops would do to the dividend
yield of a stock that normally paid out 5%. The lower the
price falls, the higher the yield goes.
Now, if a -40% price drops
seems unrealistic, consider: In 2008, of the 30,000 equities
that trade on U.S. exchanges, 4,000 of them were down
more than -40% by the end of August.
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Price Change |
New Yield |
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-10% |
5.6% |
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-20% |
6.3% |
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-30% |
7.1% |
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-40% |
8.3% |
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-50% |
10.0% |
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-60% |
12.5% |
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So in these tumultuous times, its
good to remember your yield formula.
As quality dividend payers get
dragged down by market corrections,
there is a long-term opportunity for
investors who learned their dividend
math. |
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