Consider a fictitious company, Loadsamoney Ltd, whose shares cost 100p each, which is paying an annual gross dividend of 10p per year.
The dividend yield is calculated by dividing the dividend by the share price, and then expressing it as a percentage.
In Loadsamoney’s case then, the dividend yield is:
10p/100p x 100 = 10%
Imagine Loadsamoney Ltd announces an exciting new product, which analysts believe will sell spectacularly well and thus results in a huge demand for Loadsamoney’s shares and a doubling of its share price to 200p.
The 10p dividend is the same, so the yield is now:
10p/200p x 100 = 5%
A few months later the product proves a flop, and Loadsamoney Ltd’s share price falls to 125p. However in the interim Loadsamoney has revealed its annual results and increased its dividend payment by 10% for the year, to 11p.
Again, the Dividend Yield = Dividend/Share Price x 100:
11p/125p x100 = 8.8%
The most important point to note is that the dividend yield varies with the share price. All things being equal, a rising share price will reduce the dividend yield, while a falling share price will increase the dividend yield.
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Dividends do represent a provable ability by the company to return capital to shareholders, hopefully out of distributable reserves derived from ongoing, sustainably profitable operations (and not through using borrowings, asset disposals, creative accounting or financial engineering).
However, as companies generally have more scope to pay a lower effective tax rate than their shareholders and/or have opportunities to put capital to work within the business through reinvestment (to achieve organic growth) it may, in most cases, be more useful for an investor to think in terms of the expected future total shareholder return suitably discounted for risk, rather than looking first and foremost at getting a high dividend yield.
And a significantly higher than usual dividend yield than for the relevant sector may actually suggest that Mr. Market thinks that the company in question is in trouble and will have to cut or suspend it’s dividend, or worse. Caveat emptor.