Page 44 - DIY Investor Magazine | Issue 33

INVESTING BASICS:
WHAT IS A DIVIDEND YIELD?
Payouts made by companies to shareholders – dividends – were in the news during the pandemic, as faced with great uncertainty many companies cut or cancelled them in order to shore up their balance sheets as the economic impact of coronavirus took its toll. Christian Leeming.
Those that rely on dividends on their investments as a source of income were dealt a blow, although happily markets rebounded and confidence returned.
Cash distributions send a clear message of financial well-being and future prospects to shareholders; a company’s willingness and ability to pay strong dividends over time provide good clues about its fundamentals.
Typically, mature, profitable companies pay dividends, although companies that do not are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, it often keeps the profits and reinvests them into the business – the reason few ‘growth’ companies pay dividends.
One way to identify a company at risk of cutting its dividend is to look at the dividend yield; this is simply the company’s total annual dividend per share expressed as a percentage of its current share price.
For example, if a company paid a total annual dividend of 5p a share this year, and its share price is 100p, the dividend yield would be 5%.
Dividend yield can be based on what a company has paid out during the previous 12 months to calculate the ‘trailing’ or ‘historical’ dividend yield; a risk is that past dividends may not be sustainable.
Alternatively the ‘forecast’ or ‘forward’ dividend yield can be calculated by looking at what the company is expected to pay over the coming 12 months; the risk here is that forecasts can be unreliable.
CASH DISTRIBUTIONS SEND A CLEAR MESSAGE OF FINANCIAL WELL-BEING AND FUTURE PROSPECTS TO SHAREHOLDERS
Companies are under no obligation to pay a dividend, although management teams are often reluctant to cut, as they realise that such moves are rarely welcomed by shareholders.
However, the board might decide not to pay money to shareholders if it believes that it can put that money to better use, or that the dividend is insufficiently well-covered by profits.
HOW CAN THE DIVIDEND YIELD HELP YOU TO SPOT COMPANIES IN DANGER OF CUTTING?
A firm with a very high yield compared to other companies in the market or in its sector, may look cheap, and a tempting buy; however, a high yield may indicate that investors expect the dividend to be cut – the yield is high because no one believes it will actually be paid.
If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (a) the share price is high because the market reckons the company
has impressive prospects and isn’t overly worried about its dividend payments, or (b) the company is in trouble and cannot afford to pay reasonable dividends.
However, a company with a high dividend yield might also be signaling that it is sick and has a depressed share price. Dividend yield is of little importance when evaluating growth companies because retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains.
There are several other ways to sense-check dividend sustainability.
DIY Investor Magazine · Apr 2022 44