What is dividend yield?
Dividend yield is the financial ratio of annual dividends per share relative to the price per share. The total return on share investment (equity return) is made up of two components: price yield and dividend yield. This means that dividend yield is only part of the Total Return, and in no case an extra payment.
How to calculate dividend yield?
Dividend Yield is calculated by the formula:
Dividend Yield = Dividend / Share Price
Thus, if you leave taxes and transaction costs aside, it makes no difference, whether a Share increases by 7% per year and does not pays dividend, or increases by 5%, and a dividend yield of 2%.
Does high dividend yield indicates that it's good company to invest in?
Not at all!
A high annual dividend may also result from the fact that the price of this share fell sharply in the run-up to the year.
This is easily explained by the example below:
Company X pays out a dividend of € 2 per share for three consecutive years. However, price of share falls steadily over the same period. This results in an annual increasing dividend yield, with a simultaneous fall in return on stock yield.
Dividend: 2€; Price: 80€, Thus Dividend Yield is 2,5% (2€/80€)
Dividend: 2€; Price: 60€, Thus Dividend Yield is 3,3% (2€/60€)
Exchange Rate: -25% (-20€/80€)
Equity Return: -21,7% (-25% + 3,3%)
Dividend: 2€; Price: 45€, Thus Dividend Yield is 4,4% (2€/45€)
Exchange Rate: -25% (-15€/60€)
Equity Return: -20,6% (-25% + 4,4%)
Despite the rising dividend yield, purchase of this Share is anything but a good buy, as price and equity return fall significantly.
Often companies also pay good dividends to bait buyers to buy the falling stocks.
It should also be borne in mind, that high dividends are not always accompanied by high profits. In part, they are simply a sign that the company management does not realize future investments.
So, it's quite significant that many innovative internet giants such as Alphabet (Google) or Amazon do not pay out annual dividends, because they prefer to invest all profits immediately in the development of new business fields.
Others, on the other hand, prefer to buy stocks back with dividends, which is positively seen by large institutional investors. Often this is also done because the manager's salary is tied to the performance of share price. And this of course benefits from share buybacks, while the payment of a dividend leads to a price loss.
Sometimes, business concept itself is simply not very promising. For a long time, two major energy companies were among the DAX companies with the highest dividend yields. Price of the stock itself was relatively low, although the companies made a profit, as investors saw financial problems already coming.
It is therefore absolutely not advisable to use the dividend yield, as sole selection criteria for acquisition of shares. Rather, other aspects have to be analyzed in order to develop a feasible dividend strategy.
Further Selection Criteria for Dividend Strategies
If, however, the motivated dividend collector wants to use a dividend strategy, further criteria should be taken into account.
Shares should be preferred by companies with constant or even rising dividends over the past 10 years. Companies that do this over 25 years are called Dividends Aristocrats.
Furthermore, the criterion is that, 25-75% of profits have been distributed to Shareholders in the last 3 years and dividend yield has been at least 1% in recent years.
At this point, however, we want to emphasize once more clearly that it is ultimately the total return on a stock investment and not just the dividend yield.
Are there any disadvantages of dividends?
Let us now understand the disadvantages of dividends.
1. Dividends, unlike interest, are not guaranteed
Many media praise dividends as the "new interest". However, this is not totally correct, as interest is contractually determined, while dividends are a voluntary payment of the corresponding companies, which can be deleted at any time.
These dividends are a profit sharing share for the shareholders, and it's only paid if profits have actually been made.
Like this, many companies have significantly reduced or even completely suspended their dividend in the 2008 crisis.
2. Dividends have a major impact on equity prices
If a company pays dividends over many years, this stabilizes the share price. If the dividend payments are canceled due to economic problems, the price of this share is double as investors are likely to lose shares due to lower dividends.
It should also be remembered that dividends do not constitute an additional income which is to be attributed to the price gain. The distributed dividend rather reduces the share price.
A stock with value of 50 Euros, after the dividend distribution of 3 EUR is only worth 47 EUR. This is called Dividend Discount. This correction is taken by the exchange on the next trading day.
It would therefore be equally possible to sell equities at the same rate, rather than reckon with dividend payout that leads to a loss in the value of share. Dividend Investor has therefore not received any additional income with the distribution. Instead, he even has to pay tax on the distribution and suffers a double disadvantage. (see point 4)
3. Investor has no control over Dividends
Investors have little influence over the form and nature of the dividend as this is divided at the Annual General Meeting, where of course the major shareholders will pursue their interests. The decision on special dividends or dividends in the form of shares and the absolute amount of the dividend can therefore not be influenced in practice.
This also applies to the time when the dividends are distributed or how often they are distributed.. These aspects are decided by the company and are not within the sphere of influence of small holders.
This is especially important when fiscal aspects or liquidity requirements come into play. If you have to pay your bills today, the dividend in 6 months is of little use.
4. Dividends have significant tax disadvantages
For dividends, the withholding tax must be paid in Germany in general. In addition, there is also the solidarity surcharge. There is, however, an exemption on capital gains which slightly reduces the tax burden on small investors, and shareholders can also tax their capita income according to the personal income tax rate, provided this is less than 25 percent, but still remains a considerable amount of taxes.
For many foreign dividends, such as the USA, Canada, the Netherlands, France, Switzerland or Italy, the so called withholding tax is applied which is deducted directly from the country in which the company is based. The withholding tax can be up to 30 percent of the dividend in some countries.
The most serious thing is that dividend income may not be offset against share price losses. For example, for a dividend of 2 Euros on a stock that costs 20 euros, you have to pay 0.50 euros withholding tax, although the stock is now only worth 18 euros, so the bottom line is no profit at all.
If the share price even goes down totally, a loss will ultimately be lost, but the dividend income must still be fully taxed.
5. Dividends reduce profit opportunities
If you focus on dividends alone and leave shares on the left that do not pay dividends, your selection of investment option is extremely reduced.
The system is particularly sensitive to strict criteria such as the stability of dividend (e.g. never a dividend reduction), the historical growth of the dividend (regularly rising dividends) or the duration of the dividend (in some cases over 100 years).
Who uses these criteria as a filter, misses opportunities such as Microsoft, Apple or Google. Other strong corporations such as the Warren Buffet company– Berkshire Hathaway– or Gilead Sciences did not pay dividends during the period of greatest growth. In such cases, investors waived a dividend of 2-3 percent on price gains of 20 to 30 percent per annum.
6. Insufficient risk diversification
Investors who pursue a dividend strategy generally operate so-called stop picking. The search for individual stocks according to a single search criterion negatively impacts the important risk diversification. This automatically leads to a higher risk of volatility.
And without compensating by a corresponding risk premium.
7. Exclusion of so-called small caps
Dividend Collectors neglect part of the equity market, which has surpassed the overall market by an average of 3 percent per year, the so-called small caps.
This refers to small companies with a stock market value of less than two billion US dollars. And as a rule, they do not pour out any dividends.
The omission of small caps as an asset class thus automatically leads to a renouncement of a yield optimization of the entire portfolio.