Understanding Yield in Stocks

Have you ever wished you could predict the future?

With the way the stock market has become unnervingly unpredictable, possessing this superpower would be quite helpful right now.

But, all hope is not lost and for most experienced investors, what we’re seeing in the markets isn’t new. The truth is, investing in the stock market requires vigilance, planning, and oftentimes quick reflexes. And once an investor has been in the game for a while (read: years), they develop their own set of skills to navigate the market. 🧭

For example, some stocks prove to be a safe haven in uncertain times, but the difference between tearing your hair out in frustration and keeping calm during the storm can boil down to knowing how to read stock yields. This skill can provide an investor with enough information to help them decide to invest in or avoid certain stocks—regardless of how well they may be performing in the present.

But, despite yields being listed very publicly, it often isn’t clear what they represent—and indeed, various managers will do anything in their power to bend the laws and make their metrics as good as they possibly can.

The best defense against losses and manipulation tends to be knowledge, and today, we’ll be doing our best to equip you with as much information on stock yields as possible.

What Exactly is a Yield? 📚

Yield represents the amount of money an investor can expect from their assets over a set period of time—usually monthly, quarterly, or yearly. This metric is expressed as a percentage of the current investment value based on its overall market price.

The primary yield component is the dividend—  e.g. rent when it comes to real estate—and the changes in the asset’s market value. So, to get a real quick reference for what this actually means, let’s assume that Peloton has shares valued at $200 at the time of purchase.

In this example, Peloton offers annual dividend payouts of $10 and manages to grow its shares in value by $50 within a year. This would make the total yield 30% following the above formula:

(50+10)/200 = 0.3

This is called cost yield, and we’ll be getting deeper into it a bit later down the line. Furthermore, since yield is represented as a percentage, the result gets multiplied by 100 to give us 30%.

Whenever taking yield into consideration, it is important to remember that companies may dramatically change their dividend payouts. These can either increase or decrease significantly—similar to what AT&T did in 2022 after its corporate restructuring.

Furthermore, as every investor knows, no matter how thorough the stock analysis is, there are no guarantees with regards to the future performance of securities. These two uncertainties make knowing the yield useful but not a definitive factor on its own.

An important thing to note about yield is that it is very forward-looking. That is to say, in a way, it predicts the kind of income an investment will bring in the future. This is in stark contrast with returns that look at the past performance of a company, or an expense ratio that is more or less fixed—and can often make or break a hedge fund, or an exchange-traded fund (ETF) with regards to overall profitability.

What Does Yield Tell You? 🤔

Yield can be a deceptive metric. Considering the importance of dividends for its equation, one might think yield is the parameter to look at when trying to profit from dividend investing, but the truth is more complicated.

In an ideal world, a company would increase its periodic payouts as it grows thus increasing the yield—but the increase in yield can also be a sign of a struggling firm. In essence, if the company’s shares are dropping but the estimated dividends go up it indicates the actual dollar value of the payout is a bigger portion of the overall value of stocks—which often isn’t a good sign for the long-term health of an investment.

Furthermore, a struggling company may temporarily increase its dividends to attract new investors in an attempt to get out of trouble. On the other hand, a company might choose to never pay any dividends no matter how well it is performing—notable examples being tech giants like Google and Facebook. 

These peculiarities create an environment where high-yield companies turn out to be unfortunate investments and relatively low-yield companies that can generate stellar returns. All that being said, investors can always take advantage of a high-dividend struggling company by entering a short, or semi-short position.

Investors can get away with investing in such a firm if its value is stagnating but the dividends are high—as long as they exit the position before the share price starts to decline.

How is Yield Calculated? 🧮

Considering there are numerous types of assets that use yield as a metric, there isn’t really a universal way of calculating it. However, the formula is never too complicated, and the results tend to be easy to find both by looking them up, and by calculating them.

The basic idea is that you take the realized gains—or losses—add the dividends and divide them by the principal value. The variables change from security type to security type, but the underlying principle remains the same. So, let’s examine them on a type-by-type basis.

Different Types of Yields 🗃

The most basic differentiation between the types of yield is whether it is known, or anticipated. Anticipated yield simply means that fluctuations in the value of a security are likely and expected, while known yield usually comes with assets that aren’t prone to going up-and-down at random.

Beyond these very basic types, yield can vary based on whether you are investing in bonds, weighing the pros and cons of stocks and REITs, or even going for actual, physical real estate.

On Stocks 📜

There are two distinct types of yield when it comes to shares—cost and current—and considering how many investors are flocking to high-dividend stocks amidst the heightened inflation, it is more than worthwhile to get to know both of them. In most cases, investors will pick one of them based on their preferences, but there is nothing wrong with knowing the cost and the current yield for any given stock.

The equation for calculating cost yield is the same as the example we’ve given at the beginning of the article. To reiterate, Peloton has stocks valued at $200 and has grown them by $50. Furthermore, it pays $10 in dividends annually. So: 

Yield = (Price Increase + Dividends Paid) / Purchase Price

Yield = (50 + 10)/(200) 

Yield = 0.3

To get the percentage value, multiply the number by 100. In this instance, the yield is 30%.

Looking at the same example, we can find the current yield without much effort. The big difference is that the divisor isn’t the initial value, but the current one—$250 instead of $200.

Current Yield = (50 + 10)/(250)

Current Yield = 0.24 or 24%

The price yield can be used, for example, to determine how much money an investment will make based on the investor’s expenses. The current yield can tell how willing the company is to share its fortunes with its investors—for example, will the firm raise the dividends if it does really well?

Still, you should remember that yield is forward-looking. A company may announce it is changing its dividend amount at any time and the current calculation might not reflect reality. For example, you might calculate the current yield at 24% only for the company to announce that it is raising the dividend payout from 10% to 15% to reflect its growth making the actual yield 26%.

On Bonds 📃

Considering that bonds are such a common and popular type of fixed-income security—especially in troubled times—there is little wonder that there are many important types of yield for them.

Furthermore, since bonds and other fixed-income securities aren’t exactly known to have high return rates, dividends are a particularly important element of their yield.

The simplest equation here relates to nominal yield and is:

Annual Interest Earned / Face Value of Bond

So if the face value of a bond is $100 and it pays $2 in dividends, its nominal yield is 2%. This rate is usually calculated for a single year and is repeated annually.

In the case of floating rate bonds, this percentage will change over time. Floating interest investments are particularly interesting when the FED is expected to raise its benchmark rate as the dividends will jump whenever this happens.

Furthermore, there are several kinds of special calculations for bond yield. The first that comes to mind is yield to maturity. In a nutshell, bonds, unlike stocks, have an expiry date—a day on which the debtor, the institution an investor bought the bonds from, will have to pay the money back. This is true, obviously, if an investor holds onto the bond until maturity. ⏳

Yield to maturity is calculated based on the average dividends the bond pays throughout its lifespan. If it is a 5-year bond that initially pays 2% and raises it first to 3%, then 4, then 5, and finally 6%, it’s calculated using 4% because (2% + 3% + 4% + 5% + 6)/5 = 4%.

So, using the previous formula, we can calculate nominal yield like this:

Nominal Yield = Annual Interest Earned / Face Value of Bond

Nominal Yield = (4)/(100)

Nominal Yield = 0.04 or 4%

In addition to yield to maturity, there is also yield to worst and yield to call to consider.

Yield to worst assumes that the issuer will do very poorly and fall just short of defaulting. It tries to calculate the lowest possible income for the investor in any particular bond.

Yield to call, on the other hand, falls somewhere between the previous two calculations. There are certain bonds that can be redeemed—paid back—before they are matured. This yield type is defined by its call date and is calculated using dividend payouts until the time of redeeming, and the market value.

On Real Estate 🏢

With 2022 finally bringing more real estate availability, investors might be happy to hear that real estate yield is very simple to calculate, and looks pretty much exactly as might be expected. This asset type doesn’t pay dividends, but it can generate revenue through rent.

However, rent isn’t all profit. As a respectable property owner, or a good landlord, you know that it is important to take good care of everything on the property. Property owners must make sure everything is well-maintained and all the bills are paid. 💸

When calculating yield for real estate, the price of the property , the revenue from it, and the expenses that will have to be endured all have to be considered. So, let’s say Annie wants to buy an apartment for $400,000. It can probably be rented out for $1,500 per month, and the upkeep will be $650. All this will make the real estate yield 2.55%—let’s find out exactly how.

First, the upkeep should be subtracted from the rent so 1,500-650=850

Then, since yield is calculated annually, we can multiply 850 by 12,  making it 10,200.

Finally, Annie must divide the annual profit by the property value—10,200/400,000—giving 0.0255, or 2.55%.

Real estate yield can be an insightful metric. As long as you aren’t looking to make money by selling the property once it appreciates in value enough, it can tell how long it will take to recoup the investment, or whether the property itself will be able to cover a loan taken in order to purchase it.

Such knowledge can truly be worth its weight in gold—if knowledge had an actual mass—as owning property is great, and probably not as out of reach as you might think, no matter your credit score. 💳

Real estate is generally not a bad investment, as, while it does suffer from occasional price collapses—most notably in 2008—it does have a century-long record of value appreciation.

REITs are very similar to real estate when it comes to yield. REITs are government-created trust funds that enable an individual to invest in real estate without directly buying any property. 

The big draw of these investment vehicles is that they pay 90% of their profits in the form of dividends. Thus, any yield-minded trader will find them enticing—and will have to look out for the actual profitability of the underlying properties before venturing any of their money.

Comparing Dividend Yield and Dividend Payout Ratio ⚔

The principal difference between a dividend payout ratio and dividend yield is that the payout ratio shows the amount of the company’s overall net earnings given to the investors. While it isn’t usually listed among key statistics of an investment, it can be found on a firm’s balance sheet.

Investors may find the payout ratio useful as it makes it easier to see just how viable a company’s dividend policy really is—both on the corporate and the investment side. If the ratio is too high, it might indicate that the current policy isn’t really sustainable and may become far less enticing in the near future—or might lead to real financial trouble if the company is too stubborn.

On the other hand, a very low ratio can indicate the company is very stingy when it comes to sharing profits. This really doesn’t have to be a deal-breaker if your strategy is heavily reliant on growth investments—but is a more at-a-glance metric for the purely fixed-income-minded.

Things to Consider Before Buying Dividend Stocks 👨‍🏫

While getting some money out of an investment every once in a while even before cashing out is enticing—even exciting at times—it is important to remember nearly everything has drawbacks. Indeed, high dividends are seldom the result of the boundless generosity of the board of directors.

Generally speaking, the best dividends—and the highest yield—are attached to investments that don’t really have a lot of growth potential. On one hand, holding riskless assets is a key element of nearly every portfolio, but on the other, the benefit of these investments can often be completely negated by inflation.

That being said, there are always dividend assets that appear to be crushing inflation, and this consideration is far from the only—and far from the most important—aspect that should be considered before making a purchase.

Dividend Growth 📊

A major consideration when checking the yield of a company are its prospects for growth. While getting some money every so often is great, knowing that, as the time goes by you’ll be getting a greater amount is even better. For this reason, if an investor is seriously yield-minded and serious about dividend investing, they’ll want to find firms that have spent their lifespan increasing payouts.

If you stick to dividend aristocracy and get most assets through the leading brokers for stock trading, you’ll certainly make passive income a worthy part of the overall yearly revenue. There are numerous firms that have a stable track record of growing their dividends and they tend to be fairly easy to find.

Obviously, dividend growth isn’t a good unto itself. A company that keeps increasing their payouts year after year while having consistent negative returns isn’t a true dividend growth firm—getting paid $4,000 in dividends in 2021 and $4,200 in 2022 isn’t worth much if your shares are worth $15,000 less than when they were purchased in 2020.

Stable Dividends ⏲

As good as getting bigger dividends every year is, it is equally bad being paid far less than expected. For this reason, you should always keep in mind how likely the company you are investing in is to keep doing well. A major metric that can be used here is the dividend payout ratio as it can go a long way in telling if your shares will even be able to generate dividends in a few years’ time.

Making sure that the dividends are stable isn’t a complicated matter. One just has to find how much a company has paid per share over the course of the previous 5, or 10 years. This info is generally readily available for most established firms and is a simple matter of making sure the numbers aren’t changing year in, year out. 

Depending on whether an investor is interested in the exact amount of cash, or what percentage is being paid regardless of the actual returns, they’d simply either look at the actual dollar amount, or the yield percentage itself.

However, dividend stability is not the same as financial viability. A company that is always exactly $5 per share no matter their performance isn’t necessarily a winning purchase. If their stock keeps losing value, it is both possible and likely that those negative returns will far exceed the exact dividend amount being paid. For this reason, it is paramount never to lose track of the overall financial stability of the company itself.

Financial Stability 💰

Hand-in-hand with dividend stability comes the financial stability of investments. As far as stocks are concerned, this means how likely the company is to not only stay in business but also thrive. As with nearly any other kind of trading and investing, making sure you are making the right call boils down to not being lazy.

Consulting the various tools of technical and fundamental analysis like the mosaic theory, or the Dow theory isn’t only recommended, but is also pretty much paramount.

While bonds are generally safer, they aren’t always safe. Certain bonds are considered to be junk—the issuer has a better chance to default than do anything else—and keeping an eye on bond ratings is a good way to make sure you aren’t about to lose a lot of money.

Competitive Advantages ⚖

To be frank, competitive advantages are something that one should be looking for no matter the exact investment strategy. In the long run, they are what will separate successful companies from troubled firms—and you obviously want to invest in winners, not losers. Still, you should keep in mind that competitive advantages aren’t always super easy to spot, and can vary widely from field to field.

However, an example of a business trait that tends to always be a positive is frugality. As the Ferengi third law of acquisition states—always pay as little as possible. Furthermore, not everything that appears like a clear boon really is one. For example, while Musk’s public transit systems are exciting, they are arguably worse than a regular metro system in every way save for aesthetic design.

Another apparently good trait that is as likely to be a liability as is to be an advantage is Musk’s willingness to make sudden and bold moves. On the one hand, you can’t really revolutionize space exploration by being timid, but on the other, many fear that this tendency of his can lead to bad moves—as some argue is the case with his purchase of Twitter.

Prospects for Growth 📈

As with any investment, the goal isn’t to simply find companies that will survive, but those that will thrive. While there has been a lot of focus on dividends, growth is an important part of the calculation and shouldn’t be forgotten. A high-risk asset with good dividends but abysmal performance compared to the market’s average return isn’t a very worthwhile investment. 

Now, bonds appear like prime suspects here—and they are—but bonds aren’t exactly expected to generate stellar returns in the first place. Perhaps a surprising type of asset to look out for with regards to this are blue-chip stocks. While many of them can still have massive returns, many are as likely to grow as they are to collapse—not at all.

This, obviously, doesn’t mean you should blindly and boldly trade various risky penny stocks. While startups have incredible growth potential—even Apple’s shares were worth a measly 6 cents in the very beginning—they aren’t the only growers out there. Many large corporations can tick most of the important boxes.

Johnson & Johnson—for example—is a big and established firm that has proven its financial viability over numerous years of successful operations and growth. Furthermore, it is a company that has a track record of raising its dividends every year—by 5-6% per year.

Dividend Traps ⚠

Dividend traps generally represent the cases in which a high yield means bad news. Essentially, it highlights the need to go beyond face value as yield doesn’t only go up when the dividends increase—it also rises when the value of stocks falls. 

Since none of this always leads to the same conclusions, you should be sure to employ proper analysis, maybe even using the hybrid approach of the mosaic theory—when endeavoring to discern traps from opportunities.

Fortunately, dividend traps aren’t hard to spot in most cases. It is a simple matter of seeing yield skyrocket and cross-referencing it with returns that were achieved. Seeing yield go up to 5% from an average of 2% in the previous years is a smoking gun to go and check the annual stock values.

Still, things aren’t always quite so simple. A corporation or an institution that sees trouble ahead might try to raise a rainy day fund by offering unreasonable dividends—since their shares haven’t taken a plummet yet the writing isn’t quite on the wall and the prospects for great passive income can often be more than alluring.

Conclusion 🏁

Ultimately, there is little more to say about stock yield than that it is a very worthwhile metric. It may not be—and should not be—the deciding factor for any investments, but the amount of insight it can provide is staggering. 

Unlike many other parameters in stock analysis, it has the ability to both give insight into the viability of securities for the needs of your portfolio and it can speak volumes about the health of a firm at large.

Furthermore, in recent years it has proven to be the linchpin in the wider discussion on how business is conducted. On the one hand, the need for corporations to keep cash reserves to pay out dividends can be seen as a liability in times of high inflation, but it can also be seen as a call to action for more generous wealth distribution which can facilitate further, more inflation resistant investments into the economy as a whole.

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