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How are dividend yields calculated

There's more to a dividend yield than you may think.


Feb 21, 2015 at 10:02AM

Image: Pixabay.

Dividend investors are generally interested in collecting the biggest dividend yields available – as long as they're from healthy and growing companies, ideally ones that are in relatively stable and predictable businesses. Thus, many companies are ruled out, because their high dividend yield is due to a falling stock price or because the company is in a high-yielding but cyclical industry. There's a way to grab huge dividends, though, from familiar blue-chip names -- as long as you can be patient.

I'm speaking, of course, of effective dividend yield. That's a yield calculated based on a company's current annual dividend payout in relation to your original purchase price (adjusted for any stock splits).

An example will help here, so consider Colgate-Palmolive (NYSE:CL ). a slow and steady grower, with a predictable business, as demand for toothpaste, deodorant, dishwashing liquid, and pet food isn't likely to surge or plunge from year to year. Imagine that you bought shares of back in February 1995, about 20 years ago. Back then, the stock price was around $65 per share -- which is really $5.44, once you adjust for stock splits. Back then, the dividend was $0.21 (split-adjusted) per share annually. Divide $0.21 by $5.44, and you'll get a dividend yield back then of about 3.77%. Pretty good, and even better than today's yield, of 2.1%.

Dividend yields can grow over time. (Image: Pixabay.)

The effective yield

Your effective dividend yield blows both of those out of the water, though. Take the recent annual dividend of $1.44 per share and divide it by the $5.44 (adjusted) price per share you paid for the stock, and you'll get a 26.5% yield! That might seem like a tricky or invalid maneuver, but it's not. It's showing you that you're collecting more than a quarter of your original investment amount each year in dividends -- a pretty sweet deal.

The only catch? It took 20 years to get to this point. It wasn't a wasted 20 years, though, as you collected dividends the whole time, and the value of the stock increased, too -- thus the growth from $5.44 to the recent $69.

Here's another example, Boeing (NYSE:BA ). Imagine that you bought shares back in February 1995, when it paid out $0.50 per share

in annual dividends, and traded at a split-adjusted share price of $16. That gave you a dividend yield of 3.1%. Nice enough. But today, the annual dividend amount is $3.64 (and recent yield 2.4%). If you bought at $16 per share and are collecting $3.64 per share today, your effective dividend yield is a whopping 23.7%!

Effective dividend yields above 20% aren't that uncommon, if you have patience and discipline. Nike (NYSE:NKE ). for example, paid $0.06 per share annually in early 1995, with a split-adjusted price then of about $3.77. Its yield then? About 1.6%, higher than today's 1.2% yield. But its current $1.12 annual dividend by its 1995 stock price of $3.77 gives you an effective yield of 30%.

Effective yields topping 20% are more than possible. (Image: Pixabay.)

So how can you grab big effective dividend yields for your portfolio? Well, patience is obviously key. But you also have to choose your investments wisely. Ideally, you want to invest in healthy and growing companies with sustainable competitive advantages. Ideally, you want them to be increasing their dividends regularly and significantly, too. (Over the past 20 years, Colgate-Palmolive's average annual dividend growth rate was 10%, while Boeing's was 9% and Nike's was 28%.)

It can work out well even if you don't end up with the biggest effective yields. Walt Disney Co. (NYSE:DIS ). for example, only delivered an effective yield of 8.2% over the past 20 years, but its stock grew more than sevenfold in value, averaging solid annual gains of 10%.

So next time you're looking at your long-term holdings and thinking that their dividends aren't that exciting, take a little time to calculate your effective yields. You might be surprised.

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