Dividend yield indicates how much income you should expect to receive if you buy a stock at the current price; dividend payout ratio indicates how safe the dividend is. Ideally, you want the highest dividend yield with the lowest payout ratio, but these two parameters are often mutually exclusive, so you want to find the right balance between the two.
Dividend yield is annual dividend divided by current stock price. Dividends are set in dollars and cents, and can change quarterly while the stock price fluctuates daily, so dividend yield changes daily with the stock price. The lower the stock price, the higher the dividend yield, and vice versa. For example, if XYZ pays a 50 cent per share dividend and trades at $25, its dividend yield is 2 percent. If XYZ drops to $20 while the dividend stays at 50 cents, the yield jumps to 2.5 percent. If XYZ rises to $30, the yield drops to 1.6 percent.
Dividend payout ratio is the percentage of profits paid out in dividends. If XYZ earns $1 a share and pays out 50 cents in dividends, its payout ratio is 50 percent, but if it earns 55 cents and pays out 50 cents in dividends, its payout ratio jumps to 91 percent.
The lower the payout ratio, the safer the dividend: A low payout ratio means that a company still has plenty of money to plow back into the business or to increase dividends in the future; a high payout means that a company may not have enough money for other purposes and may need to cut the dividend to conserve cash. At the least, this indicates the company is not in a position to increase the dividend unless its earnings improve drastically. A dividend payout ratio of 70 percent or less is generally considered safe: The dividend is well covered if earnings drop unexpectedly, and can even increase, especially if earnings grow. A payout of 80 to 90 percent is high risk: The dividend is not likely to increase, and if earnings drop, the company may need to cut it. A payout of over 100 percent is clearly unsustainable, and the dividend will likely be cut or eliminated.
Investors are generally willing to pay more for stocks whose dividends are well covered -- that is, have low payout ratios, so their yields tend to be lower. On the other hand, investors tend to shun or even sell stocks with high dividend payout ratios, so their yields tend to be higher. If you're looking for dividend income, rank stocks by dividend yield first and then eliminate those with the highest payouts.
- The Boston Institute of Finance Stockbroker Course: Series 7 and 63