What is dividend yield, and why is it important to consider? 

When investors consider dividend investing, the dividend yield is often used to help determine which companies to invest in. 

A dividend is a regular cash payment or additional shares issued by a company to its shareholders and investors as a way of distributing a portion of its profits.  

While dividend yield can be a useful metric, it should not be relied on solely, as there are potential pitfalls. 

We reveal the key details you must know about dividend yield, including the pros and cons. 

What is dividend yield? 

The dividend yield represents how much a company pays out in dividends annually relative to its share price and is expressed as a percentage.  

It can help investors estimate returns and compare the dividend yield to that of other investments that can generate income.  

However, it’s worth stressing that the value of your investment could still go up or down, and you may not achieve the desired returns.  

Investors must consider a range of factors when deciding to invest, including how the company generates profits, the sector in which it operates, the financial health of the business and its outlook, as well as the opportunities and challenges it faces. 

How do you calculate dividend yield? 

To calculate the dividend yield, you need to divide the value of the annual dividends per share by the current share price and then multiply by 100. 

You’ll need to check how often the dividend is paid, as it typically occurs quarterly or annually. However, some companies may pay dividends more often. 

Here’s an example of how to calculate dividend yield. If a company pays £1 in annual dividends and the share price is £30, the dividend yield would be around 3.3%.  

There are also one-off dividends, known as special dividends, which are distributed under certain scenarios, such as after a company sells a division or reports strong earnings.  

You should exclude any special dividends when calculating the dividend yield. 

It’s also a good idea to calculate the dividend yield of any investments regularly, as this can rise or fall.  

What affects dividend yield? 

There are a few factors that can impact the dividend yield of your investment: 

• The share price: If the share price of a company falls, the dividend yield increases as the dividend now represents a higher percentage of the share price. The opposite is also true – so if the company’s share price rises, the dividend yield falls. 

• The dividend payment: The dividend yield rises if the dividend is increased but will fall if the dividend is cut or stopped.  

• The type of company you invest in: If you invest in a high-quality and stable business with a history of consistently paying dividends, it’s more likely payouts will continue (and maybe increase in the future). Some companies may choose not to pay dividends and instead reinvest in the business.  

The above factors can be impacted by many things, such as the performance of the business, the outlook, how the sector is faring, economic and market conditions, and any news and trends. 

This is why it’s so important to get a complete understanding of a company before investing, so you’re fully aware of the risks.  

What is seen as a high dividend yield? 

The average FTSE 100 dividend yield is around 3.5%, which is perceived as strong as it falls between 2% and 5%.  

While it may seem tempting to chase the highest dividend yield possible, you should be wary when considering anything above 5%, as the dividend may not be sustainable.  

A high dividend yield could suggest higher risk and represent a ‘dividend trap,’ which investors should try their best to avoid. 

With a ‘dividend trap,’ investors can be caught off guard by a high dividend yield as the company may be struggling. This can lead to a lower share price or even the dividend being cut if it’s unsustainable. If this happens, the share price can fall further.  

Looking at many factors, such as the company’s financial health, whether they previously paid or increased their dividends and future forecasts, can help avoid a dividend trap. 

You could also look at the dividend cover, which will show how many times a company’s profits can cover its annual dividend. A number of at least two means the dividend is seen as safe. 

Of course, this number can change, so it’s worth regularly reviewing.   

What are the pros and cons of dividend yield? 

There are many advantages and disadvantages of dividend yield to consider. 

The pros of dividend yield 

• It can provide useful insights: With the dividend yield, you can know the regular income to expect, provided the dividend yield doesn’t change.  

• A stable or growing dividend yield may suggest a healthy company: Looking at the dividend yield, both historically and in future forecasts, may reveal financially healthy businesses. Dividend-paying companies also tend to be more stable.  

• Dividend yield can signal confidence from the company: A stable dividend yield combined with a history of payouts implies that management is confident in its outlook and doesn’t need to reinvest more in the company.   

The cons of dividend yield 

• A reduction in the dividend can affect your returns: If the company is struggling with challenging conditions, the dividend could be cut or stopped, impacting returns.  

• Maintaining dividends can impact company growth: A business paying dividends won’t be able to use the money to reinvest for growth.  

• High-yielding dividend companies can be misleading if you don’t research: While it may be tempting to search for high-yielding companies and invest, you could end up in a dividend trap, so it’s recommended you do your research or consult a financial adviser.  

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