Dividend Yield and Dividend Growth Stocks
This article explains how to accurately calculate dividend yield and outlines the criteria and pitfalls for identifying dividend growth stocks that consistently increase their dividends.
What is Dividend Yield?
Dividend Yield is the ratio of the annual dividend received per share relative to the share price. The formula is 'Annual Dividend Per Share (DPS) ÷ Current Share Price × 100'. For example, if a share price is $50,000 and the annual dividend per share is $2,000, the dividend yield would be 4%.
It's important to note that the denominator is the 'current share price'. Even if the dividend amount remains constant, the dividend yield increases if the share price falls, and decreases if the share price rises. This means dividend yield is a figure that fluctuates daily, not only based on a company's dividend policy but also on the market's valuation of its share price.
This article provides an educational explanation to help understand the metric and does not recommend buying specific stocks. Even if two stocks have the same 4% yield, the underlying reasons can be entirely different.
Why You Should Look at Payout Ratio Together
Looking solely at dividend yield doesn't tell you if a dividend is safe. The Payout Ratio, which indicates how much of a company's earnings are distributed as dividends, is calculated as 'Dividend Per Share ÷ EPS'. If EPS is $5,000 and the dividend is $2,000, the payout ratio is 40%.
An excessively high payout ratio means that most of the earnings are being used for dividends, increasing the risk of a dividend cut if performance falters even once. Conversely, if the payout ratio exceeds 100%, it means the company is paying out more in dividends than it earns, which can lead to borrowing or capital impairment, raising doubts about sustainability.
Therefore, even with a 4% dividend yield, a company with a 40% payout ratio carries a different level of risk than one with a 95% payout ratio. It's essential to develop the habit of checking not just the yield number, but also the earnings power supporting that dividend.
The Perspective of Dividend Growth Stocks
Dividend growth stocks refer to companies that have consistently increased their dividends year after year, rather than just those with a high current dividend yield. In the U.S. market, there are categories like 'Dividend Aristocrats,' which are companies that have increased dividends for 25 consecutive years or more, demonstrating stable cash flow and a commitment to shareholder returns.
The power of growth is built over time. Even if the dividend yield at the time of purchase is 3%, if the dividend increases by 8% annually, the dividend amount will double in about 9 years. Even if the share price remains the same, the 'Yield on Cost' will rise to 6%. This structure means that while the initial yield may be low, the effective yield grows over time.
The Korean market is also seeing an increasing number of companies adopting quarterly and interim dividends, along with a trend of strengthening shareholder return policies. However, many Korean stocks have a shorter history of dividend growth compared to their U.S. counterparts, making it even more important to directly verify dividend trends over the past few years.
The High-Dividend Trap — Distinguishing Value Traps
When a dividend yield is abnormally high, caution is warranted. As previously noted, since the denominator is the share price, if the share price plummets due to poor performance or negative news, the dividend yield will mechanically skyrocket. For example, if a stock with a $3,000 dividend sees its share price halve from $60,000 to $30,000, its dividend yield jumps from 5% to 10%.
Such a 'yield boosted by a falling share price' is often a signal of an impending dividend cut. If the dividend is indeed reduced, the yield will fall again, and investors may also incur principal losses due to the prior share price decline. This is known as a value trap.
Therefore, when you encounter a high dividend yield, you should first ask 'why is it so high?' The key is to distinguish, using the payout ratio and earnings trends, whether it's due to increased earnings and sufficient capacity, or an illusion created by a collapsing share price.
Taxes and Net Received Amount are Also Part of the Yield
Dividends are subject to taxes upon receipt, so the stated yield and the net received yield differ. In Korea, dividend income is subject to withholding tax, and if annual financial income exceeds a certain threshold, it may be subject to comprehensive financial income taxation. Dividends from U.S. stocks are subject to withholding tax in the U.S., with the difference from Korean tax standards settled domestically.
You also need to understand ex-dividend dates. After the ex-dividend date, the right to receive a dividend disappears, and theoretically, the share price adjusts by the dividend amount. This is why a strategy of buying just before the ex-dividend date solely to capture the dividend does not guarantee a simple profit.
Specific tax rates and deduction criteria can vary depending on the regulations, so it's accurate to check your account type and current tax laws before making an actual investment.
Summary of Key Checkpoints
In summary, dividend yield is a ratio calculated as 'DPS ÷ Share Price' that changes daily, and looking at it in isolation can lead to overlooking risks. It's meaningful only when you also check the sustainability of the dividend through the payout ratio and its growth potential through past dividend trends.
Here are the items to check when making an investment decision: First, is the high dividend yield due to strong earnings or a sharp drop in share price? Second, is the payout ratio at a sustainable level relative to earnings? Third, is there a history of dividend increases over several years? Fourth, is it still attractive based on the net amount received after accounting for taxes and ex-dividend adjustments?
Ultimately, dividend investing is less about a single year's yield number and more about buying into the financial strength of a company that can consistently grow that dividend. This article is an educational resource to help interpret metrics, and investment decisions are solely your judgment and responsibility.
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