Dividend Yield - Buy and Hold Investments Strategy

Reduced share prices offer opportunities to investors seeking income through dividends when buying into the market. They may receive increased dividend yields which equate well to other forms of investment income options.

The dividend yield is a way of comparing the dividend you receive versus the current market “value” of a share - “What percentage of the current market price am I getting back when I receive a dividend payment?”

It is also a way of comparing the income from shares directly to the income from interest rates available on bank accounts and deposits.

Formula: dividend yield = (dividend per share / market price) x 100%

Example: Company “ABC”

Dividend per share  = $0.30 Current market price  = $2.00 Dividend yield  = ($0.30 / $2.00) x 100%    = 15% Initial Investment Value  = 5,000 ABC shares @ $2.00 each    = $10,000 worth of ABC shares Dividend yield  = 15% Expected return on $10,000  = $1,500

 
It is important to note that the dividend yield is affected by the daily changes in the market price of ABC shares and the future earnings potential of the company, therefore the expected return can fluctuate from day to day.

Calculating a dividend yield

Refer to the fictional scenario below:

Formula: dividend yield = (dividend per share / market price) x 100%

Day 1 If the market price of ABC shares is $2.00 per share and the dividend per share is always constant at $0.30, then the dividend yield is 15% Formula: $0.30 / $2.00 x 100% = 15% On Day 1, the (potential) return on your initial investment of $10,000 is $1,500. If a purchase is made at $2.00 on DAY 1, the dividend yield is "locked in" at 15% and will not alter unless the dividend amount ($0.30) changes. Day 2 If the market price of ABC shares is $2.20 and the dividend per share is $0.30, then the dividend yield is adjusted to reflect the change in the market price and becomes 13.6%. Formula: $0.30 / $2.20 x 100% = 13.6% On Day 2, the (potential) return on your initial investment of $10,000 is $1,360. If a purchase is made at $2.20 on DAY 2, the dividend yield is "locked in" at 13.6% and will not alter unless the dividend amount ($0.30) changes. Day 3 If the market price of ABC shares lowers to $1.90 and the dividend per share is still $0.30, the dividend yield is adjusted to reflect the change in the market price and becomes 15.8% Formula: $0.30 / $1.90 x 100% = 15.8% On Day 3, the (potential) return on your initial investment of $10,000 rises to $1,580. If a purchase is made at $1.90 on DAY 3, the dividend yield is "locked in" at 15.8% and will not alter unless the dividend amount ($0.30) changes.

The effect of the current market price on the dividend yield

The reason that a low share price creates a high dividend yield (and vice versa) is due to the fact that the dividend per share is dictated by the company’s level and distribution of earnings to shareholders, regardless of how high or low the market price of the share is.

If the market price of ABC shares doubles due to positive developments within the company, the dividend remains the same and therefore the percentage paid out to shareholders in the form of dividend payments, based on the doubled share price, is comparatively lower.

If you purchased when the share price was $2.00 per share, a $0.30 dividend is 15% of the value of 1 ABC share. If the share price suddenly doubled and you purchased at $4.00 per share, a $0.30 dividend is 7.5% of the value of 1 ABC share.

So even though the share price of ABC has doubled and the company is obviously “doing well”, the dividend per share is not adjusted to reflect the newfound success of the company. In comparison to the “value” of a share in ABC ($4.00), the dividend paid per share ($0.30) is a relatively low percentage of the market value, at only 7.5%.

If ABC’s share price hit troubled waters and the share price fell and you purchased at $3.50, a $0.30 dividend is now a greater percentage of the market value – 8.6%.

Other options

If the on market price of your shares is lower than your initial purchase price, you can still earn money through your dividends because the dividend yield is higher. If the dividend yield is low due to the on market price being higher than your initial purchase price, you can still earn money by selling your shares on market because the price per share is higher than your initial purchase price.

Forecasting dividends

The dividend paid by the company to distribute profits to shareholders may be hard to forecast. Companies offer guidance on what the earnings and dividends might be throughout the year. These are announced through the stock exchange (like this seen here) or may be available in the investor centre on the company’s website. Larger, more stable and dominant companies with inflexible demand tend to offer similar dividends from year to year, even during tough economic periods.

Investing with a bank

Interestingly, the return on a $10,000 deposit in a savings account or a term deposit at a bank doesn’t always measure up to the (potential) return available to an investor who owns ABC shares.

Refer to the fictional scenario below:

	Initial investment value	= $10,000
	Interest rate	= 4.00% p.a.
	Expected return on $10,000	= $400 (assumes interest paid at maturity)

Even if interest rates rose to 6.00%, the expected return ($600) is still less than what a 6.7% dividend yield would provide ($670).

Of course the risks involved in share trading greatly outweigh the risks you face when investing your money with a bank, so it pays to consider if you would be prepared to choose a higher but riskier (potential) return, or if you would prefer to opt for a lower but safer (potential) return. You must decide whether the premium on the potential income offered is worth the investment, as opposed to putting the money in the bank where the interest rates being offered only just beat inflation.

Interest rates
You can view interest rates offered by financial institutions in New Zealand at interest.co.nz.

Source: ANZ Securities Limited