Why to calculate dividend yield of a stock before investing

High growth stocks will not turn up in your stock screen. You have to use fundamental analysis to evaluate the company to know whether a stock is right for investment. Selection of financial toll for analysis depends on the investment goal you have in your mind. If you are a dividend investor, then a couple of key metrics should be part of your investing strategy to analyse the stock for investment. One of such key tools is dividend yield.

Dividend yield is a financial ratio used to calculate a company’s dividend payout relative to its current market price. 

Formula to calculate dividend yield

Dividend yield is calculated by dividing the value of dividend per share for a year by the market price per share of the stock.

For example, if a company’s dividend per share is 5 rupees and the current market price is 100 rupees, then its dividend yield is 5% (5/100). If a company has paid quarterly dividends, then you need to add all of them to get the annual dividend per share.

The dividend yield formula is as follows:

Dividend yield = annual dividend per share / market value per share

What dividend yield tells you

Dividend yield calculates the amount of dividend that the company has already paid in proportion to the current market price of the share. Therefore, it tells you the probable amount of return you will be getting back every year for your per share investment.

Which means, if your dividend yield is 5% and your per share amount invested is 100 rupees, then your probable dividend income for the year would be 5 rupees per share. As it gives you the rate of return per year, investors also refer to it as the rate of investment for a stock without any capital gain.

You can also use the dividend yield of two or more stocks to decide which stock is better for investment from a dividend prospective. For instance, suppose you have two companies, XYZ System and ABC System. Also, suppose that both the stocks have paid dividends of 5 rupees per share per year. Company XYZ system’s share is trading at Rs 100 per share and ABC system’s share is trading at 200 per share.

In this case, you need to calculate dividend yield to understand which company can give you a good rate of investment for your long term dividend investing strategy. Dividend yield of company XYZ System is 5% (5/100) and ABC system is 2.5% (5/200). By comparing the dividend yield of both the companies, you can select the XYZ system as it is giving you more return per year in comparison to the ABC system.

Please note, selection of stock should not only be based on high dividend yield. You should also use all other fundamental analysis tools to know how the company is fundamentally sound from an investing point of view. You should also look for the dividend history of the company and its future prospects before investing. In general, old established companies are more consistent than new companies.

List of things you should look at in addition to dividend yield

There are several key parameters you should consider before investing. We have listed few of them for your reference;

  1. History of earning growth and dividend payments
  2. Company’s financial position such as debt-equity ratio
  3. Is the dividend sustainable
  4. Is there a increase in per share dividend every year
  5. Can the company grow over time
  6. What its fundamental analysis tells you

Dividend yield can come down if the stock price has temporarily come down due to market uncertainty. Instead of completely relying on the mathematical dividend yield figure, you should also verify all the details that are required for dividend investment strategy.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.