Dividend yield is a critical concept for investors—especially dividend growth investors. If you’re going to find success in investing, then you need to have a deep understanding not only of how to calculate different kinds of yields, but you need to know how to use them effectively as portfolio-building tools. At its most basic level, yield is simply the annual dividend amount divided by the stocks current price. However, there are a lot of powerful and useful things you can do with yield—things most retail investors aren’t aware of!
We’ll look at how you can use yield analysis to improve your portfolio performance later in the article but, first, let’s dive into the different types of dividend yield and how to calculate them.
Dividend yield is a ratio that provides you with a given rate of return for a stock based solely on its dividend payment. For example, if a stock has a current yield of 5%, then you would receive a 5% return on your investment through dividends if you were to purchase the stock at its current market price.
This alone provides us with some useful information, such as how long it will take for our investment to double in value (i.e., a 100% return on our investment). This can be accomplished two ways: using the “Rule of 72” or the Time Value of Money (TVM) formula.
The Rule of 72 provides us with a simple estimate of how long it will take for our investment to double in value based on its dividend yield. To use this method, you simply divide “72” by the current yield of the stock. In our example above, we would divide 72 by 5 and find that it will take roughly 14.4 years for our investment to double in value based on its current dividend yield.
Obviously, with dividend growth investing, we are anticipating the dividend payment—and therefore our yield-on-cost (YOC)—to increase over time. As this happens, the amount of time needed to double our investment will decrease.
Note, if you are reinvesting those dividends, then you should use the “Rule of 69.3” instead. By using 69.3, you are able to take compounding into account. In this case, it would take roughly 13.9 years to double our initial investment.
The Rule of 72 only provides us with a rough estimate. If you want to know the precise time needed, you can use the Time Value of Money (TVM) formula. The easiest way to do this is to use Excel—thanks to the “nper” (number of periods) formula that automatically calculates the time needed for us.
The formula is nper (rate, pmt, pv), where rate is your current yield, pmt is the annual dividend amount, and pv is your initial investment.
Here’s an example:
Using the time value of money, we find that it will take 14.21 years to double our investment based on a 5% dividend yield.
Before you can calculate the dividend yield for a stock, you need to decide which type of yield you want to calculate: current yield or yield-on-cost (YOC).
The current yield represents the dividend yield you would receive if you bought shares at the current market price. On the other hand, yield-on-cost represents the yield you are currently receiving for shares of stock you previously bought at a different price.
Calculating current yield is simple. You simply divide the stocks current annual dividend by its current market price.
While it is good to know how to do this, most financial websites do this for you. For example, here is E*TRADE’s data for 3M (MMM):
While current yield is good to know for initiating or adding to positions in your portfolio, a much more useful yield is what is referred to as yield-on-cost (YOC). YOC tells you what your current dividend yield is based on a price you paid in the past.
For example, if you bought 3M at $150 per share but it is now trading at $172.61, then you aren’t really interested in what the current yield is—you want to know what your YOC is.
Calculating yield on cost is just as easy, you simply use your average cost instead of the current market price:
YOC is ultimately what matters for the dividend growth investor. Let’s take a quick look at an example to demonstrate why:
Let’s say you buy shares in company XYZ at $50/share. The stock is paying an annual dividend of $2.50 or a 5% current yield.
The following year, XYZ raises its dividend 5% (to $2.62) and the price is now trading at $59. The current yield would be 4.4%.
If you purchased shares now, you would actually have a lower starting yield. However, because you purchased your shares at $50, you now have a yield-on-cost of 5.24%–higher than your original starting yield thanks to that dividend growth!
Over time, as companies in your portfolio continue to grow their dividends, your YOC just continues to rise. I know dividend growth investors that started decades ago that now have a YOC in the 50% range. That means their initial capital investments are doubling every 2 years!
That’s the amazing secret sauce of dividend growth investing—compounding passive-income, with a growth kicker!
An important corollary to this is that, as your investment capital matures, it drives your YOC higher. Likewise, as you continue to build your portfolio and deploy new capital, it drives your YOC lower—because it is being put to work at current yields, which are typically lower than your yield-on-cost.
This provides three YOC ramifications for all dividend growth investors:
My article When’s the Best Time to Start Dividend Growth Investing addresses the first of these points directly—I highly encourage reading it!
In the above examples, we were focused on yields for individual stocks. Let’s take it up a notch. What if you want to know what your dividend yield is for your entire portfolio? Well, you can calculate that too!
Calculating a yield for a portfolio requires weighting the individual stocks within it, and then calculating how much yield each one contributes to the whole.
First, you need to calculate the weighting for each stock in your portfolio. To do this, you simply divide the current value of the position by the total value of your portfolio:
Now, you’re ready to calculate your total portfolio dividend yield. To do this, you are going to take the sum of the weighted yields:
Remember, if you want the current yield of your portfolio, use the current yield of each stock. Likewise, if you want your portfolio’s yield-on-cost, then use the YOC for each stock.
The easiest way to do this is to use Excel and make a simple spreadsheet to do all the calculations for you. Here’s an example:
Again, the yield you select determines whether you get your current yield or yield-on-cost!
If you want to know the current yield of your portfolio, M1 Finance makes this super simple to find. Simply use the research tab to drill into your portfolio—they will provide you with your current portfolio yield:
Remember, this is your current yield–meaning, a dollar of new capital invested into your portfolio (as you have it allocated) will produce this dividend yield. Again, this is NOT the yield you are actually receiving from your portfolio. That would be your yield-on-cost.
If you want to know your portfolio’s current yield-on-cost, M1 Finance also provides you with most of the data you will need. All you will need to find is the current dividend payment for your stocks.
For example, they provide you with your average price for each stock:
If you needed the average price components, they also provide you with each stock’s cost basis and number of shares:
Finally, they provide you with the current value of each stock position:
This data makes it super quick and easy to setup your spreadsheet and calculate your portfolio’s current yield-on-cost.
I highly recommend using M1 Finance for your dividend growth investing. Their platform provides an excellent user experience (e.g., powerful, intuitive and easy to use on both desktop and mobile), is completely free, enables you to leverage fractional shares, can be easily setup for auto-investing and auto-reinvesting, and you can get started building your portfolio with as little as $100!
I personally use M1 for all my dividend growth portfolios—including our site’s passive-income portfolio that we share with the public.
If you’re interested in starting your own M1 Finance dividend growth portfolio, please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash!
That’s just one more reason to start your dividend growth investing today! It’s never too soon to start working towards your financial freedom!
Dividend yield is important to investors for a number of reasons. In a lot of ways, it represents the pulse of a dividend-paying company. As such, it is an indicator of the company’s health—providing an early-warning system for both opportunities and threats.
There are good yields and bad yields. A high yield may be an indication of great value, but it could also be an indication of a broken company with a plunging stock (aka value trap). Context is always king. Yield alone isn’t enough. You need to analyze that yield within the context of the company’s fundamentals, including its payout ratio (i.e., is the dividend sustainable).
As dividend growth investors, growth in dividends is the primary driver or catalyst for our long-run returns. However, that doesn’t mean we want to settle for a portfolio full of low-yielders in the short-run!
We want the best yield we can get for quality companies that possess dividend growth potential. Dividend growth investing is a marathon—not a sprint. But, if we can start the race at mile-marker three, four or even five (with a higher starting yield), why wouldn’t we want to???
Furthermore, I recommend building a portfolio with a mix of yields. You want some lower-yielding stocks with high long-run growth potential, some higher-yielding stocks with lower long-run growth potential, and then a mix of stocks in between those two.
While we want the benefits of the long-run growth, the high-yield positions provide us with current passive-income that—when reinvested—can provide us with some kindling to jump start our compounding.
However, the most important way you can use dividend yield—and one that very few retail investors utilize—is as a powerful and highly-effective value filter. Let’s take a closer look at how we can do that…
Ratios are a great tool for comparison analysis. Like price-to-earnings (PE) ratios (which are used extensively by investors), dividend yields can serve a similar purpose—enabling us to perform comparison analysis on companies.
While PEs can provide investors with beneficial insights when broadly comparing stocks (e.g., against other stocks, an industry, a sector, or even the broader market), yield is most beneficial to us when comparing a stock against itself—meaning against its own historical trend or range (e.g., over 5 or 10 years).
The top of the yield range (high yield) represents potential value opportunities (a low price to dividend ratio). The bottom of the yield range (low yield) indicates that the stock may be overvalued (a high price to dividend ratio). I use the terms “potential” and “may” because, as we’ve seen, yield must always be analyzed within its broader context.
For example, a company’s yield may be at the top of its historical range because there is a fundamental problem (bad) or because of a market overreaction (good). Likewise, it may be at the bottom of its range because it’s simply overvalued or there may be developments that have fundamentally shifted the company’s value–and therefore price–higher (i.e., the stock has been repriced by the market).
However, generally speaking, a company’s yield will move within its historical range and we can use that information to identify value opportunities—initiating or adding to positions when good value presents itself.
Let’s take a look at an example. Let me be clear, this is just an example to illustrate the technique—it is not a full analysis of the company nor a recommendation to buy or sell the stock. Again, I just want to demonstrate how dividend yield can be used as a beneficial part of your investment research—an additional tool in your dividend growth investing toolbox.
Let’s look at the 3M Company (MMM) 5-year dividend yield trend:
Note: Remember, yield rises as price falls (or dividends increase). Thus, a yield chart is like looking at an inverse price chart. Hence, you would theoretically want to sell at low points and buy at high points when utilizing a yield chart–the complete opposite of a price chart!
First, I like to calculate the mean, one-standard-deviation limits, and two-standard-deviation limits. This provides me with some useful structure on the chart.
From statistics, we know that—for a normal distribution—68% of the data will fall within one standard deviation from the mean. Furthermore, 96% will fall within two standard deviations.
I also like to look at the actual distribution of the company’s yields to analyze how close to “normal” it is. For this period of time, MMM’s distribution is fairly normal—skewed slightly towards lower yields and with a long, but thin, tail to the high end (mean is highlighted in orange).
I like to focus on one primary zone: the value (buy) zone.
This is the range between +1 and +2 standard deviations. Stated differently, over the five-year period, we would expect MMM to have a lower yield than the bottom of this range at least 84% of the time. In this zone, the company is historically undervalued—a place I like to lock-in yield and value.
The flip-side of this is true as well: there is a zone between -1 and -2 standard deviations that represents an overvalued range—a place I like hold what I’ve got and avoid initiating new positions or adding to existing ones.
This approach is supported by the fact that each time the yield reached the undervalued/overvalued zones, it typically reverted back towards the mean.
Furthermore, we see that MMM became extremely overvalued once and is currently extremely undervalued. An extreme reading indicates that the company’s yield was lower (if undervalued) or higher (if overvalued) 98% of the time!
Finally, given MMM’s skew toward lower yields, the current extreme undervalued reading is even more significant.
Again, extreme undervalued readings can be unbelievable value opportunities (generated by major overreactions by the market to a short-run catalyst)… or they can be dreaded value traps (i.e., a broken company). You would need to do more analysis and research to determine for yourself which option is the case with MMM. However, the data—absent of a massive fundamental problem with the company—supports the hypothesis that this would be an excellent time (a statistically very rare opportunity) to buy MMM.
Note: The spike in yield indicated on the chart for MMM was the result of cuts to earnings forecasts by the company–resulting in a selloff. The question investors must answer is: Was this selloff a short-run over-reaction by the market to negative news from an otherwise quality company? Or, does it represent a more long-run, fundamental problem with MMM?
If the first option is correct, then this is a massive opportunity to buy the company at a fire-sale price. If the latter is true, then it represents a downward re-pricing of the stock and a potential value trap.
The point I’m trying to drive home is that this approach (Yield Analysis) helps you to identify value opportunities for further research and avoid initiating or adding to a position when a company’s stock is overvalued. As such, it’s a beneficial tool (when used in conjunction with other techniques) that far too few dividend growth investors take advantage of.
Understanding dividend yield is critically important for investors—especially dividend growth investors. Yield can provide advantageous insights into both companies and your portfolio. Furthermore, yield analysis can help you identify value opportunities… and avoid buying into overvalued prices.
As always, you can view our site’s dividend growth portfolio (aka our Wicked Capital PIP—or passive-income portfolio) by simply clicking https://m1.finance/1zUclN2JL and follow our portfolio updates by clicking here or on the “Our Portfolio” link in the top menu bar!
We personally use and recommend M1 Finance for your dividend growth portfolio—the platform is intuitive, powerful, free, and enables you to use fractional shares. If you’re interested in starting your own M1 Finance dividend growth portfolio, please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash!
That’s just one more reason to start your dividend growth investing today! It’s never too soon to start working towards your financial freedom!
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