When someone invests in a stock, they usually want something in return. Many companies meet this demand by paying a cash dividend, or a share of the profits. Not all companies pay dividends, but those that do tend to be older and more established. The question for investors is, how does the dividend measure up against how much money they paid for the shares?

A dividend calculation offers an answer to this question. Although this ratio doesn’t offer a complete picture, it can be useful when analyzing a potential investment.

What is dividend yield?

The dividend yield formula compares a stock’s dividend to a company’s share price. A higher percentage indicates that the company pays a higher dividend relative to the stock price. Many exchange-traded funds (ETFs) and mutual funds also pay dividends and the same calculations are used to determine the dividend yield.

Although dividend yield alone won’t tell the whole story about a stock, it can help demonstrate how much investors can reasonably expect to receive from that stock during a year. It also enables investors to analyze the stock’s performance over time and identify trends.

There is no hard and fast rule for determining what is a good dividend yield. In general, though, many investors consider a dividend yield between 2% and 5% to be positive.

How to calculate dividend yield

Dividend yield is calculated by dividing a stock’s annual dividend by its stock price.

Dividend yield = Annual dividend/stock price

For example, if a stock paid investors $1.50 per share in a year and the stock price at the time of calculation was $40 per share, the dividend yield would be 3.75%.

Dividend yield is often calculated using the previous year’s financial results. If things have changed since those results were released, however, this number may not give the most accurate view. For this reason, there are a few different ways investors may want to calculate dividend yield:

• Investors can multiply the most recent quarterly dividend by four, then divide that number by the latest stock price.
• Investors can add up the most recent four dividend payments (called a trailing dividend) and divide that number by the current stock price.
• If a fund or ETF pays monthly dividends, investors can multiply the most recent dividend by 12 or add the previous 12 (trailing) distributions and use that figure to calculate an updated dividend yield.
  

These methods also come with limitations. For example, if the company offers unbalanced dividends—paying less in the first three quarters and then offering a larger dividend in the fourth, for example—this number may also be skewed.

Advantages of dividend yields

Dividends offer several advantages, like additional cash flow and a tax rate that may be lower than ordinary income.

• Additional cash flow.

  Dividend stocks provide investors with an added source of cash flow, which may be reinvested. A dividend reinvestment strategy allows investors to continually grow their portfolio, even without contributing additional funds out of pocket.

• May be taxed at a lower rate than ordinary income*.

  This can help to reduce an investor’s tax burden without reducing their cash flow.
  

*Dividends may be either ordinary (nonqualified) or qualified, each with its own tax rates. Nonqualified dividends are taxed as ordinary income, according to the investor’s existing tax bracket. Qualified dividends, however, are taxed at either 0%, 15% or 20%.

Qualified dividends are those which are owned for a minimum holding period (more than 60 or 90 days, depending on the dividend payout schedule) and are issued after December 31, 2002 by an eligible US or foreign corporation.

Disadvantages of dividend yields

While a dividend payment may seem like a good thing, dividend yield isn’t a fool-proof way to determine the health of a stock.

‍Can be misleading. Dividend yield can paint a potentially misleading picture of a stock’s promise, for two reasons. One is timing. Dividend yield can be variable based on when it is calculated and the company’s dividend payment schedule. The other is the dividend yield’s relationship to a stock’s value. A sharp rise in dividend yield may be the result of a sudden decline in stock’s price.

Dividend yield vs. dividend payout ratio

The dividend payout ratio is different from dividend yield and can offer another way for investors to analyze a company’s progress and growth. This ratio is the company’s total dividend payout to all shareholders divided by the company’s net income for that same time period.

Dividend payout ratio = Total dividend payout / Company’s net income

The payout ratio indicates what percentage of the company’s overall earnings are distributed to investors. This differs from the dividend yield, which tells investors what percentage of a stock’s share price they can expect to earn back in the form of dividends.

As with the dividend yield, trends in this number can help investors analyze a company’s progress over time. As a rule of thumb, when the payout ratio starts approaching 100%, it can be a warning sign that a company may not be able to keep paying its dividend in full.

Dividend payout ratio doesn’t provide a complete picture on its own, though, and may need to be combined with other calculations to truly gauge the investment’s value.

The bottom line

Expressed as a percentage, dividend yield compares a stock’s current price to its annual dividend payout to investors. This can be a useful calculation, helping investors analyze a company’s progress over time and determine what dividend payouts are likely to look like per share. Still, a dividend yield may not offer investors a complete overview of the stock’s health and stability, nor is it a guarantee of future dividends.‍