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Everybody watches the stock indexes to determine whether to invest in a particular company. But did you know there is a way to see if you might get a return on your investment even if the stock price doesn't change much?

One handy way for investors to evaluate a stock or company's performance beyond its share price and price-to-earnings ratio is its annual dividend yield.

What Is Dividend Yield?

A dividend is essentially your share of the profits of a company whose stocks you own. When you buy stock in a company you aren't only gambling on the stock price of the company going up, you're purchasing part ownership in that company. Ownership of stocks - participation in ownership of a company - gives you two rights: to have a vote in electing the board to run the company, and to be paid a share of the company's profits, at the discretion of the board. So one way to evaluate whether or not you wish to own part of a company - by purchasing its shares - is to determine its annual dividend yield, or what percentage of the company's profits you are likely to be given for each share you own.

The dividend yield is a way to estimate the dividend-only total return of a stock investment. If the dividend is constant, the dividend yield will, as with bonds, fall if the value of the stock rises; it will rise if the value of the stock falls. That's why, if a stock is falling quickly, the dividend yield may look surprisingly high.

Dividend yield is a ratio between a company's stock price and its annual dividend. When a dividend changes infrequently, the ratio will rise when the stock price falls, and fall when the stock price rises.

Savvy investors with faith in their investments will reinvest their dividends, giving them even more opportunity to earn more dividends in the future.

How to Calculate Dividend Yield

To calculate dividend yield, divide the annual dividend of a company by its share price. Then multiple the result by 100: dividend yield is then represented as a percentage.

Dividend Yield = Annual Dividend / Current Stock Price

There are essentially three different ways to calculate the annualized dividend figure to use to calculate dividend yield. You can use the total dividends paid in a company's most recent full fiscal year; the total dividend paid over the past four quarters, or even the most recent dividend multiplied by four.

As an example, take Apple Inc. (AAPL - Get Report) . The company has paid a dividend of 73 cents per quarter since its first quarter in 2018. Before that, and for four quarters, it paid 63 cents per quarter. So we could say in its four quarters before Q1 2018, the company had an annualized dividend of $2.52 (63 cents for four quarters). Or, we could calculate all of its latest four quarters, which is $2.82 (73 cents for three quarters in 2018, plus 63 cents for its last quarter of 2017). Its average 52-week share price, calculated by adding its 52-week low ($142 as of Tuesday, Jan. 22) to its 52-week high ($233.47) was $187.74. So its dividend yield would be either 1.34% or 1.5%. The third method, projecting its annualized dividend being consistent with the last three quarters, or 73 cents per share, for 2018 (with its Q4 dividend yet to be paid) means its annualized dividend of $2.92 would have a dividend yield of 1.6%.

Or, for the visual formula learner (like me):

Dividend Yield = Annualized Dividend (Four quarters' total)/Average Stock Price

Problems With Relying on High Dividend Yield 

High dividend yields can come at the cost of growth potential. Every dollar a company pays in dividends to shareholders is a dollar not being reinvested by the company in growth or generating capital gains. Sometimes, companies not doing as well as the previous year will still pay the same quarterly dividend, to keep investors happier with their investment.

Shareholders can earn high returns if the value of their stock increases while they hold it.

However, even if a stock price remains the same, at, say $100 a share, with 100 shares and a dividend yield of 10%, a shareholder can buy another 10 shares with the $1,000 in dividends, meaning the shareholder will receive a dividend of $1,100 the following year if the ratio remains constant.

That's why more mature companies that aren't growing as quickly as a new company tend to pay higher dividend yields, and why market staples and utilities tend to pay higher yields.

Why Is the Dividend Yield Important?

Dividend yield is important for investors because everyone likes to get paid some of the profit when a company is doing well. And dividends have been an important part of total returns on investments over time.

According to research done by Hartford Funds, since 1960, 82% of the total return of the S&P 500 Index is the result of reinvested dividends and the power of compounding, as with the example of the 100 shares above.

The ability of a company to consistently pay a dividend can be seen as indicating the company has been making money and expects to continue to do so. However, things to be wary of include a rising interest rate environment, which can cause stocks with good dividends to lose value dramatically. And a company starting to pay a dividend could be a company that sees no other use for cash, meaning growth through acquisitions or expansion is less likely.

Problems and Risks Associated With Dividend Yield Investing

  • The dividend data used can be old or inaccurate. Also, many companies have a very high yield while their stock price is falling, and might be just before the dividend is cut.
  • Published or popular dividend yields can be calculated using data from the last full year's financial report.
  • The longer it has been since the full year report, the less relevant that data is for investors.
  • The last four quarters can be used to calculate a trailing 12 months of dividends, but it can make the dividend yield too high or too low, depending on whether the dividend has been raised or cut.
  • Another method is to take the most recent quarterly dividend and multiply it by four to get the dividend for the year. The problem with this is that not all companies pay an even quarterly dividend, and some pay dividends on a basis other than quarterly. And some firms outside the U.S. pay a quarterly dividend, and a larger, year-end dividend. If the year-end dividend is larger than the quarterly dividends, and the calculation is performed after the larger dividend is paid, it can give an inflated yield.
  • And some companies pay dividends even more frequently than quarterly. Calculating an annual dividend from a monthly dividend could result in a calculation that is too low.
  • When deciding how to calculate the dividend, investors should look at the company's history of dividend payments to determine which method will give the best results.
  • Investors should also be careful looking at a distressed company with a higher dividend yield. A strong downtrend can increase the quotient of the calculation dramatically.

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