When it comes to stock investment, investors often looks out for stocks with higher dividend yeild. Dividend yield is an important tool for investors, who prioritize income generation. But higher dividend yeild is not alwsys a good thing in stock market investment.
Dividend yeild represents the annual dividend income an investor can expect to receive relative to the stock's current price, expressed as a percentage. Many get excited seeing stocks with 5% – 6% dividend yield, thinking *“Free money every year”. But, it can also be a TRAP.
How?
Let’s break it down, with some simple explanation. But before that, it is important to understand, what is Dividend Yield?
Suppose, If a company gives $ 10 dividend and its stock price is $ 100, then,
Dividend Yield = (10 ÷ 100) × 100 = 10%
So, if dividend yield has to increase —
- Dividend has to go up
Or - Stock price has to go down
And here is the problem — Sometimes the yield looks high because the stock price is falling, because the business is in trouble.
So what should we really check before making any decision?
The answer is Payout Ratio!
Payout Ratio = Dividend per Share ÷ Earnings per Share
This shows how much of the company’s profit is being paid out. The ideal range is 25%–40%
If it’s too high, like nearing 60% or 90% . The company may not be reinvesting enough for future growth.
It is further to be noted that, Dividends are just a bonus, not the main reason to invest. In the long run growth creates Wealth.
In good faith - Peace!!
