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Why is the dividend yield (Dividend divided by market price) of a stock a valuable parameter to consider when evaluating a stock? By looking at it, what can one infer about the stock?

edit: Thanks for the answers. But I wish to know why the parameter is dividend/market price rather than just 'dividend'? What 'extra' info you can uncover by looking at dividend/market price that you cannot get from 'dividend'?

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up vote 1 down vote accepted

But I wish to know why the parameter is dividend/market price rather than just 'dividend'? What 'extra' info you can uncover by looking at dividend/market price that you cannot get from 'dividend'?

Consider two stocks A and B. A offers a dividend of $1 per year. B offers a dividend of $2 per year. Let's remove all complications aside and assume that this trend continues. If you were to buy each of these stocks you will get the following amounts over its life (assumed infinity for simplicity):

cash flows from A = $1/(0.04) = $25, assuming risk free is 4% per annum

cash flows from B = $2/(0.04) = $50, assuming risk free is 4% per annum

The price you buy them at is an important factor to consider because let's say if A was trading for $10 and B for $60, then A would look like a profitable nvestment while B won't. Of course, this is a very simplistic view. Dividend rates are not constant and many companies pose a significant risk of going bust but this should help illustrate the general idea behind the D/P ratio.

P.S.:- The formula I have used is one for computing the NPV of a perpetuity.

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Thanks. Can you please shed some light on : 'assuming risk free is 4% per annum'? What is risk free –  Victor123 Jul 6 '11 at 16:34
    
@kaushik en.wikipedia.org/wiki/Risk-free_interest_rate --hope it helps. –  Monster Truck Jul 8 '11 at 20:50
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The dividend yield can be used to compare a stock to other forms of investments that generate income to the investor - such as bonds. I could purchase a stock that pays out a certain dividend yield or purchase a bond that pays out a certain interest. Of course, there are many other variables to consider in addition to yield when making this type of investment decision.

The dividend yield can be an important consideration if you are looking to invest in stocks for an income stream in addition to investing in stocks for gain by a rising stock price.

The reason to use Dividend/market price is that it changes the dividend from a flat number such as $1 to a percentage of the stock price, which thus allows it to be more directly compared with bonds and such which return a percentage yeild.

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Dividend yields can also reflect important information about the company's status. For example, a company that has never lowered or stopped paying dividends is a "strong" company because it has the cash/earnings power to maintain its dividend regardless of the market. Ideally, a company should pay dividends for at least 10 years for an investor to consider the company as a "consistent payer."

Furthermore, when a company pays dividend, it generally means that it has more cash than it can profitably reinvest in the business, so companies that pay dividends tend to be older but more stable.

An important exception is REIT's and their ilk - to avoid taxation, these types of funds must distribute 90% of their earnings to their shareholders, so they pay very high dividends. Just look at stocks like NLY or CMO to get an idea. The issue here, however, is two fold:

  1. They don't have a long history of paying dividends. This is never a good sign.
  2. The REIT model is similar to S&L's in the past or banks in general - borrow money cheap and invest it at a higher rate of return. Once rates rise, borrowing becomes expensive, and earnings will drop, so dividend yields will drop, and that will make the stock price fall as well.

So a high dividend can be great [if it has been paid consistently] or risky [if the company is new or has a short payment history], and dividends can also tell us about what the company's status is.

Lastly, taxation on dividend income is higher than taxation on capital gains, but by reinvesting dividends you can avoid this tax and lower your potential capital gain amount, thus limiting taxes.

http://www.tweedy.com/resources/library_docs/papers/highdiv_research.pdf is an excellent paper on dividend yields and investing.

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Dividend is usually paid in form of extra shares, not money...right? So where does the tax come in? I am not getting money so on what am I being taxed? –  Victor123 Jul 6 '11 at 16:39
    
@Kaushik - That's actually incorrect. Dividend can be extra shares i.e. stock-based dividend, but dividends are generally dollars paid per share owned. For example, Intel pays a dividend of 18 cents USD per share, and they will pay 21 cents per share starting in the 3rd quarter. –  BlackJack Jul 6 '11 at 17:27
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Probably the most important thing in evaluating a dividend yield is to compare it to ITSELF (in the past). If the dividend yield is higher than it has been in the past, the stock may be cheap. If it is lower, the stock may be expensive.

Just about every stock has a "normal" yield for itself. (It's zero for non-dividend paying stocks.) This is based on the stock's perceived quality, growth potential, and other factors. So a utility that normally yields 5% and is now paying 3% is probably expensive (the price in the denominator is too high), while a growth stock that normally yields 2% and is now yielding 3% (e.g. Intel or McDonald'sl), may be cheap.

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Dividends yield and yield history are often neglected, but are very important factors that you should consider when looking at a stock for long-term investment.

The more conservative portion of my portfolio is loaded up with dividend paying stocks/MLPs like that are yielding 6-11% income. In an environment when deposit and bond yields are so poor, they are a great way to earn reasonably safe income.

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How are they safe? They may be stopped any time. No? –  Victor123 Jul 6 '11 at 16:30
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