Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Decoding the Dividend Yield Formula

A stock's yield is calculated by dividing the per-share dividend by the purchase price, not the market price.

Price and yield move in opposite directions. As stock prices rise, dividend yields go down. As stock prices fall, dividend yields rise.

Let's look at an example: A fictitious stock trades for $100 a share and pays a $5 dividend. You don't even need a calculator to determine its yield: It's 5%.

Conventional thinking is that if the price of this mythical company rises, say to $200, then its dividend yield will fall. And indeed it will -- it will be cut in half. $5 / $200 = 2.5%. But that only applies to investors who bought the shares at the new price. The investor who bought at $100 is still earning a 5% yield.

But here's where things get interesting -- and profitable. If the share price moves in the other direction, down, and it drops to $50, then the dividend yield will rise: $5 / $50 = 10%.

Once again, though, that's only true for the investors who bought their shares for $50. The investors who bought at $100 are still earning their 5%. For most investors, yields do not "change," they're only "established." And their stocks keep paying that yield unless the company's actual dividend payout changes.

Yield has nothing to do with the current market price -- only the current dividend, and the price you paid for your shares. If you bought your shares at $100, a $5 dividend earns you 5% no matter what happens to the share price, again assuming the dividend remains constant.

That's why a bear market presents an immediate opportunity for investors seeking significant dividend income. Most stocks are deep into the red: Here at home the S&P 500 Index is down -20.% for the past 12 months, with most world indexes similarly in the red. Stocks in China are off -64.9%. These depressed prices mean dramatically higher yields. When a market falls -50%, its yields double.

And here's the kicker: When you buy a stock with a depressed price and a high yield, you lock in that outsized yield, just as if you'd put your money into a CD and locked in the interest rate.

Remember: Buying a stock just for the dividend alone is a bad idea. Dividends are never guaranteed. And a high yield isn't always a good thing -- some of these companies could be worthless tomorrow, like Freddie. You want the same traits in a dividend payer as you would in any other company you're considering: A solid financial footing and a strong history of rising profits and dividend increases.

No serious income investor should wait to lock in such rich income streams. You can't afford to sit on the sidelines. Bear-market buying opportunities just don't come around very often. Most of the time, of course, that's a good thing. But since a down market is already here, you might as well profit from it by locking in these extraordinarily high yields.

You see, no company -- or very, very few -- set out to pay a 10%-plus yield. That's a healthy yield no matter where you go. In this country, a 5% dividend stream is above average, even robust. But in a down market, even a 5% yield can rise dramatically, purely because stock prices are falling. That's the power of the dividend yield formula.

Take a look at our table. It shows what various price drops would do to the dividend yield of a stock that normally paid out 5%. The lower the price falls, the higher the yield goes.

Now, if a -40% price drops seems unrealistic, consider: In 2008, of the 30,000 equities that trade on U.S. exchanges, 4,000 of them were down more than -40% by the end of August.       

Price Change       New Yield

      -10%                 +5.6%
      -20%                 +6.3%
      -30%                 +7.1%
      -40%                 +8.3%
      -50%                 +10.0%
      -60%                 +12.5%

So in these tumultuous times, its good to remember your yield formula. As quality dividend payers get dragged down by market corrections, there is a long-term opportunity for investors who learned their dividend math.