When putting together a portfolio of stocks, the expected dividend income should be one of your key considerations. Dividends can provide a steady stream of cash flow and, especially when the stock market is going through a tough patch, make up for the lack of price appreciation in your stock holdings. The dividend-to-stock-price ratio is therefore an important financial metric.
Corporations periodically share their profits with stockholders by making cash disbursements, known as dividends. Such payments can occur once, twice or four times a year, depending on the firm's policies. Generally companies only pay out some of their earnings in the form of dividends and reinvest the rest into the business to stay competitive. Dividend payments must be approved by the board of directors. Such approvals are publicly announced, along with when the payments will be made. The board will also make non-binding statements about its future dividend policy, so shareholders can better assess their financial prospects.
The best way to assess the dividend income of a diverse group of stocks is to compare their dividend yield. To calculate this ratio, divide the annual dividend paid by the firm per common stock, by the most recent stock price. Finally, multiply the result by 100 to convert the figure into a percentage. If the firm makes multiple dividend payments per year, add up all the dividends paid per common share over the last 12 months. Corporations sometimes get an unexpected cash flow and pay a special or one-time dividend. Ignore such dividends in your calculations as they are not representative of what you can expect to earn in the future.
Assume a particular stock is trading at $20 and the issuing firm has made three dividend payments over the last year. The company paid 50 cents per stock in ordinary dividends in January and July, followed by a onetime dividend of $1.25 in December. The onetime dividend was prompted by the favorable outcome of a lawsuit that awarded the firm several million. To calculate the dividend yield, add up the ordinary dividends, which equal $0.50 plus $0.50 equals $1. Ignore the onetime dividend. To arrive at dividend yield, divide the total annual dividend by the stock price and multiply the result by 100. So the dividend yield is $1 divided by $20 times 100 equals 5 percent.
Dividend Payout Ratio
Another useful ratio is the dividend payout ratio, which equals dividends paid per share divided by earnings per share, multiplied by 100. In some instances, you need to calculate the diluted earnings per share, instead of simply the earnings per share. As the name implies, the dividend payout ratio tells you what portion of its earnings the firm is paying to shareholders. If the firm in our example had earnings per share of $2 and paid $1 in dividends, its payout ratio is $1 divided by $2 times 100 equals 50 percent. We can therefore infer that this firm is paying half of all profits to shareholder, while investing the other half back into the business. If well managed, such a firm may be poised for significant growth.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.