Owning dividend-paying companies can be part of a well-diversified portfolio, but it can also be a mathematical trap. As a quick refresher, companies have the option of paying their investors dividends in cash or stock. Most dividends are paid in cash and are on a per-share basis. For example, ABC company is currently trading at $10 and pays an annual dividend of 30 cents per share. If an investor owns 250 shares of ABC, they should expect to receive $75 over the next year. ABC’s stock is yielding 3%.
Annual Dividend Payment = Annual dividend x # of Shares
$75 = $00.30 x 250
Dividend Yield = (Annual dividend / Share price) x 100
3% = ($00.30 / $10.00) x 100
“Should I buy (fill in the company name), it’s currently yielding (usually a high yield, 7-15%)?” At face value, that question seems logical, and the yield sounds terrific. Let’s assume the person said ABC company is currently yielding 10%. A $50,000 investment in ABC would pay $5,000 a year. If you’re focused on the $5,000, you’re good.
If you bought ABC for its 10% yield, you might be disappointed when you find out that ABC’s stock price is down 70%. Instead of the stock trading at $10 a month ago, it’s currently trading at $3.
10% = ($00.30 / $3.00) x 100
With a 70% downturn in the stock, it’s unlikely the dividend can stay at its current 30 cents a share for an extended period. And, as the stock recovers, the current yield will decrease. The unexpected upside is you’ll have capital appreciation, but that’s now why you bought ABC in the first place. When ABC gets on the recovery train and trades at $7, your 10% yield will be 4.28%.
If you’re going to buy a stock because of the income it pays, make sure you understand what you’re buying. Are you purchasing the quarterly/annual dividend or the current yield? Without proper due diligence, you could fall victim to the mathematical trap of the current yield.
This is a hypothetical illustration and is not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions