Let’s start by looking at calculations that measure dividend yield.
Dividend yield is a good way to determine if a stock aligns with investment objectives. A low dividend yield may indicate that the company is focused on growth. While a higher dividend yield often indicates that the company is established and mature. However, there is a balance. An excessively high dividend yield could be a red flag if the dividend yield has increased simply because there has been a precipitous decline in the stock’s price. As you approach double-digit dividend yields it becomes nearly impossible for a company to support the payment for the long-term.
Keep in mind that the dividend yield ratio varies significantly from industry to industry. Comparisons between companies should only be made within the same industry.
Forward or Trailing Dividend Yield
Dividend Yield can also be viewed as either forward or trailing. Forward dividend yield is a projection of the annual dividend amount investors will receive. It is expressed as a percentage of current share price and is calculated by annualizing the most recent dividend payment. It is best used when a company has a history of consistent or increasing dividend payments and is therefore, likely to continue to pay a regular dividend payment over the next 12 months.
When a company has a history of inconsistent dividend payments, it is best to use trailing yield. Tailing yield is calculated like Forward Yield except it uses actual DPS over the previous 12 months instead of just the last dividend payment.
Yield on Cost (YOC)
YOC is very similar to dividend yield, but it uses your cost basis to determine yield instead of the current share price. It is calculated by dividing your annual DPS by your cost basis per share. For example, let’s say you have 100 shares of a stock that has an annual dividend per share of $3.60 or $0.90 quarterly. And we will say that your cost basis is $40 per share. In this example, your YOC would be 9% annually.
Now, if you want to calculate your Dividend Yield, you will use the current share price, which we will say is $48. So, your DY would be 7.5%. In this example, your YOC would be 9%.
When you use YOC, you must adjust your cost basis each time you buy new shares. It can become very high if the stock price appreciates a lot after your purchase. So, YOC is more useful on long-term holdings when the current price is significantly different than the current price.
While YOC is important to evaluate your existing holdings, it is not useful when you are evaluating new stocks to add to your account.
After-Tax Yield is used to compare income on securities taxed at different rates, like ordinary or qualified. Simply stated, it is your dividend yield reduced by your tax rate. Let’s compare a security that pays an ordinary dividend to a Qualified dividend from a common stock.
A popular REIT pays $5 per share and a stock pays $4.50 per share. REITs are typically taxed at your ordinary tax rate which we will estimate as 25% for this example. A stock dividend meeting certain criteria can be a Qualified Dividend taxed at 15%. Your take-home income on the REIT would be $3.75, and the stock’s income would be $3.83. Even though the REIT has a higher payment because it is taxed at a higher rate, the final income of the stock is higher.
Measures of Financial Health
In addition to ratios that focus on yield, it is important to have a working understanding of ratios that allow you to quickly analyze a company’s financial health and valuation compared to others.
Earnings Per Share (EPS)
EPS is an indication of a company’s profitability. It represents the portion of a company’s profit that is allocated to every individual share of the stock. And as such, is a measurement of a company’s value. It is often used when investors are determining whether to buy shares.
The basic formula for EPS is net income minus preferred dividends divided by the number of outstanding shares.
A better way to view EPS is to use the Diluted EPS, which measures a company’s value if all its convertible shares were exercised. In other words, Diluted EPS is “diluted” by all potential shares outstanding and will be equal to or lower than basic EPS. Diluted EPS is useful because it shows a worst-case scenario for shareholders.
To calculate the diluted EPS, you would subtract Preferred Dividends from a company’s net income and then divide by average outstanding shares plus dilutive shares.
Dividend Payout Ratio (DPR)
Dividend Payout Ratio (DPR) is the percentage of a corporation’s net income that is paid out in dividends. Investors like to analyze the dividend payout ratio because it provides a picture of how safe a company’s dividend is and how much room it has for future growth. It is calculated by dividing total dividends by net income.
The percentage of earnings that the company pays illustrates their commitment to paying dividends. However, an excessively high DPR can make continued growth risky and can be an indication that future dividend cuts are likely if earnings decline in the future.
Dividend Growth Rate
Dividend Growth Rate is the percentage increase of the dividend payment during a certain period of time. It allows you to evaluate a company’s long-term profitability. It is calculated year-by-year, but the 5-year growth rate tells a better long-term picture.
The formula is (Current Dividend Divided by Previous Dividend) minus 1 Dividend by Years. To calculate DGR you will need data for two periods of time. For example, let’s say a company paid a $2.60 dividend in 2020 and in 2015, their dividend was $2.05. After dividing 2.60 by 2.05 and subtracting 1, you can see that the dividend grew a total of 26.8% over the 5 years. By dividing by 5, you get their annual dividend growth rate, which is 5.36%.
A growing dividend payment helps keep up with inflation and like DPR, it also demonstrates a commitment to paying dividends.
Price/Earnings Ratio (P/E Ratio)
P/E Ratio helps determine if a stock represents a good value. It can also be used to compare a stock’s current value to its past or projected future. Keep in mind, a low share price on its own does not mean that a company is undervalued.
A stock is undervalued when it has a low share price relative to how much the company earns. Every company has a different share price, different number of shares issued, and different earnings, so the P/E Ratio offers a good measuring stick to easily compare companies.
Share price divided by EPS is the P/E Ratio formula. It is expressed in terms of times. For example, if a stock has a share price of $50 per share and its EPS is $5 per share, its P/E Ratio will be 10 times.
A low P/E Ratio can indicate a good value, but it can also indicate limited growth potential. A high P/E ratio is not always bad. In fact, it may indicate greater expected growth. Like dividend yield, P/E Ratio can also be trailing or forward. And it can be used to compare stock’s current value to its past or projected earnings. The benefit to P/E ratio is that enables you to determine whether a stock is trading at a premium or discount in comparison to similar companies.
Price-to-Earnings-to-Growth Ratio (PEG Ratio)
PEG Ratio takes P/E ratio a step further. It determines a stock’s value while also factoring in the company’s expected earnings growth over a period of time (typically 1-3 years). So, it provides a big picture look at the stock.
A lower PEG may indicate an undervalued stock and be useful when your goal is to find growth at a good price. PEG is calculated by dividing your P/E Ratio by the EPS growth rate.
Many investors desire a PEG Ratio less than 1. PEG is particularly useful when comparing companies in the same industry
Ratios offer you an efficient way to select stocks, analyze your portfolio, and manage your positions. However, ratios should not be evaluated in isolation. They are most useful when they are used to compared to companies within a similar sector and industry. They are more effective when you view them in conjunction with other factors and ratios.