The Illusion of Dividend Yield

If you are choosing stocks to invest in, one of the indicators you may look at is dividend yield.

When you are calculating dividend yield, you put the expected dividend per share in the numerator and the price you are going to pay in the denominator. A proxy for the expected dividend per share is the last-year dividend per share. You can expect that a stable company may payout the same or a higher dividend at the end of this financial year.

So, you calculate the dividend yield, and a few stocks come out as very attractive, but you need to breakdown the high dividend yield and find reasons.

You can get a high dividend yield from a stock in two ways.

Think about what’s in the numerator and denominator. Either the company continues to pay an increasing dividend and the price remains the same, or the company pays the same or a lower dividend relative to previous years’ dividend but the price of the stock drops significantly.

Let’s think of the second situation. You expect the company to pay the same or a higher dividend as last year, but the price of stock has fallen significantly in recent times, giving you an opportunity to fetch a handsome dividend yield. But this is not that simple. You need to ask why the price dropped. Does the market (that means the majority of the participants in the market) realize that the company will run out of capacity to pay the same dividend it paid in previous years? Is there any fundamental change? Is the market expectation or price drop justified?

If it’s the first scenario, you need to ask if the last year’s dividend was a one-off. Is it reasonable to expect that the company will pay at least the same dividend as last year?

For companies like banks, there should be other considerations as well. Let’s say a bank pays high dividends for some years. A high dividend payout comes at a cost as well for the bank. When a bank makes large payouts, it also lowers its capital growth. A lower growth in capital also means a lower growth in asset expansion. Lower growth in asset expansion means lower potential for future dividend payouts. Sometimes, aggressive dividend payouts can even pose a major threat to a bank’s sustainability if it faces a capital shortfall.

Look at things holistically.

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