A dividend is cash money paid to you just for holding shares of a stock or mutual fund. This money is usually paid on a monthly or quarterly basis. If you hold an individual stock you’ll get cash deposited into your account, if you own a mutual fund you can elect to either take the cash or have the dividends automatically reinvested into the purchase of more (sometimes fractional) shares.
Lets do a quick example on how to calculate the dividend yield. Suppose you buy 100 shares of PaperChase Corp at $25 per share. PaperChase Corp pays a quarterly dividend of $0.50 per share, or $2 per year per share. $2 / $25 = 8%, or the dividend yield for PaperChase Corp stock is 8%. Easy!
Suppose you watch the stock price rise to $30/share and you get excited and tell your friend Erica she needs to get in on this hot investment. Erica obliges and buys 75 shares of PaperChase Corp, but note her dividend yield will not be the same: $2 per year per share / $30 per share equals a 6.6% yield.
Also note that you own 100 shares of PaperChase Corp and Erica owns 75. Your annual income will be $2 per share x 100 shares = $200. Erica’s annual income would be $2 per share x 75 = $150. This income can also act as a cushion if the stock price goes down. Suppose after a year PaperChase Corp’s share drops to $20. Your loss would appear to be ($20 – $25) * 100 shares = -$500. However since you also earned $200 dollars in dividends your actual loss would only be -$300 (-$500 + $200). The math works the same if the share price rises back up to $30, then if you sold your total return would be ($30 – $25) * 100 + $200 = $700 (a 40% return on your investment).
REITs (real estate stocks) and utilities are two sectors that usually have higher dividend yields as well as stable dividend growth. This makes them great options for investors who desire consistent amount of cash flow from their investment portfolio. Growth stocks (e.g. Tesla, Netflix, Facebook) usually don’t offer dividends, investors are attracted to these stocks because they assume the company is reinvesting all of its profits fueling the company’s rapid growth and rise in the share price. Investors won’t care about missing out on a 3% annul yield if the stock price goes up 50%.
You have to be careful with stocks paying an abnormally high dividend yield because dividends can also be used as a reward for taking risk. Think about high yield (or junk) bonds, these bonds pay investors more to hold them because the company issuing them has some credit worthiness issues. To get investors to accept their suspect credit they have to reward them with a much higher yield. When you calculate the dividend yield for a stock your interested in be sure to compare it to its competitors. Typically the yields should be similar, if your stock’s yield is an outlier that might be a red flag.
You can find dividend information of individual stocks and mutual funds via sites like Yahoo! Finance or MSN Money. You can review years of dividend history to see if the company’s yield is rising or falling over time. If the dividend amount is rising year after year it might signal the company has strong, growing sales and revenue and thus has the more and more cash available to pay increased dividends. If the dividend rate is shrinking you might have to do some research to see if the company is in trouble.