What is dividend yield?

Dividend yield is the financial ratio of annual dividends per share relative to the price per share. The total return on share investment (equity return) is made up of two components: price yield and dividend yield. This means that dividend yield is only part of the Total Return, and in no case an extra payment.

How to calculate dividend yield?

Dividend Yield is calculated by the formula:

Dividend Yield = Dividend / Share Price

Thus, if you leave taxes and transaction costs aside, it makes no difference, whether a Share increases by 7% per year and does not pays dividend, or increases by 5%, and a dividend yield of 2%.

Does high dividend yield indicates that it's good company to invest in?

Not at all!

A high annual dividend may also result from the fact that the price of this share fell sharply in the run-up to the year.

This is easily explained by the example below:

Company X pays out a dividend of € 2 per share for three consecutive years. However, price of share falls steadily over the same period. This results in an annual increasing dividend yield, with a simultaneous fall in return on stock yield.

Year 1:

Dividend: 2€; Price: 80€, Thus Dividend Yield is 2,5% (2€/80€)

Year 2:

Dividend: 2€; Price: 60€, Thus Dividend Yield is 3,3% (2€/60€)

Exchange Rate: -25% (-20€/80€)

Equity Return: -21,7% (-25% + 3,3%)

Year 3:

Dividend: 2€; Price: 45€, Thus Dividend Yield is 4,4% (2€/45€)

Exchange Rate: -25% (-15€/60€)

Equity Return: -20,6% (-25% + 4,4%)

Despite the rising dividend yield, purchase of this Share is anything but a good buy, as price and equity return fall significantly.

Often companies also pay good dividends to bait buyers to buy the falling stocks.

It should also be borne in mind, that high dividends are not always accompanied by high profits. In part, they are simply a sign that the company management does not realize future investments.

So, it's quite significant that many innovative internet giants such as Alphabet (Google) or Amazon do not pay out annual dividends, because they prefer to invest all profits immediately in the development of new business fields.

Others, on the other hand, prefer to buy stocks back with dividends, which is positively seen by large institutional investors. Often this is also done because the manager's salary is tied to the performance of share price. And this of course benefits from share buybacks, while the payment of a dividend leads to a price loss.

Sometimes, business concept itself is simply not very promising. For a long time, two major energy companies were among the DAX companies with the highest dividend yields. Price of the stock itself was relatively low, although the companies made a profit, as investors saw financial problems already coming.

It is therefore absolutely not advisable to use the dividend yield, as sole selection criteria for acquisition of shares. Rather, other aspects have to be analyzed in order to develop a feasible dividend strategy.

Further Selection Criteria for Dividend Strategies

If, however, the motivated dividend collector wants to use a dividend strategy, further criteria should be taken into account.

Shares should be preferred by companies with constant or even rising dividends over the past 10 years. Companies that do this over 25 years are called Dividends Aristocrats.

Furthermore, the criterion is that, 25-75% of profits have been distributed to Shareholders in the last 3 years and dividend yield has been at least 1% in recent years.

At this point, however, we want to emphasize once more clearly that it is ultimately the total return on a stock investment and not just the dividend yield.

Are there any disadvantages of dividends?

Let us now understand the disadvantages of dividends.