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Calculating dividend yield

Date: Mon Jan 04 2021 ; Tags: Personal Finance »»»» Investing

Since the cut in taxes on dividends by the Bush Administration (part of his bad tax breaks for the rich strategy to get re-elected), dividend-paying stocks have been getting more attention. One of the measures, yield seems so simple but leads to confusion.

Yield is basically the return you get from an investment, as a percentage, or: 

yield = (income / price) * 100
The mathematics are simple enough, but there are several ways of interpreting this, and therein lies the rub. Even experienced investors get it confused, such as this Motley Fool article How to Achieve 20% Yields.

The title of that article is misleading. Maybe the author would describe how to use leverage to amplify your earnings? Or maybe he's gonna talk about buying junk bonds? Or maybe he's got some friends named Luigi and Bruno who are really good at enforcing loan repayments? If you read the article it's none of those.

Instead his strategy is to buy any old dividend paying stock, and wait. The trick is to find a dividend paying stock that will be regularly increasing its dividends, so that when you wait long enough the 2% yield you probably got will become a 20% or more yield 10 years down the road. Sounds great doesn't it?

Unfortunately there are several things that strategy doesn't account for. If you go to any stock quoting web site, the yield quoted will likely stay hovering in the 2% range for that whole time you're waiting. So if the current quoted yield is only 2% then how are you getting 20%? Simple. Some tricks are being played on you.

To explain, let's redefine the yield equation a bit: 

current yield = (income / price)
yield on investment = (income / cost basis)
Now I've got two kinds of yields. What's the difference? It's in the bottom part of the division. The current yield is what the stock quoting services tell you, and it's based on the current dividends and current price. The tendency the market shows is that for a dividend paying stock, as the company raises the dividend, the market bids up the price. Hence, for a consistent dividend-raiser stock the price will tend to always go up.

Yield on investment is what the Motley Fool guy is talking about when he says it's easy to get 20% yields. He's taking the price you originally paid for the stock holding, your cost basis that is, and dividing that into the current dividend payout. As the dividend payout increases, then so will your effective yield (based on the cost basis).

There's a big thing not being factored into the equation. Can you see it? It's the effect of inflation. The money 20 years ago was worth more than the money today, so it's really unfair to compare a current dividend payout with a 20 year old cost basis. To make it a proper comparison the cost basis ought to be adjusted for inflation. That way you can see whether the rising dividend has stayed ahead of inflation, or not.