When an investor puts up the cash for an investment there is always a reward expected. From a pure financial investment perspective, this reward can come in one of two forms. It can come in the form of cash or it can come in the form of capital growth. The latter takes a longer time to bear fruit so investors who have shorter time horizons look to cash rewards. This cash reward or income is called in financial markets, Yield.
Yield, for the purpose of evaluating an investment, is therefore the expected income return on an investment. Now, Yield is not just limited to one particular type of investment. This is why an investor could come across different yield rates such as bond yields. Investors that invest in stocks mostly are usually more concerned with dividend yield. This dividend yield is the equivalent of dividend income divided by stock investment.
So for example, if an investor puts $20 per share in ABC Inc. and gets a $1 return, the rate of return on that investment would amount to 5%. In terms of stocks, there are general composite rates of return and there are specific rates of return. Stocks as a general class may have a particular rate of return when compared to another class, such as bonds. But within this general class of return there will be industry or sector specific rates of returns. An investor looking to invest in an oil company may find that the rate of return differs from that of a biotech company. And dividend yields may vary at the company level, too. So that ABC Inc. with a 5% dividend yield could very well have higher or lower yield than XYZ Inc. in the same sector.
There is also another peculiar feature of dividend yields – they change, often in a very short space of time. When this happens it can be a source of investors who’ve already bought stock in a company, and for investors looking to make their initial investment. An example will help to show how this change creates confusion.
Let’s say an investor puts up $20 a stock in ABC Inc. at a 5% dividend yield. The return on this will be $1 at the end of the year. That same investor may become perpelxe4d if he or she looks in the newspaper and sees ABC Inc. quoted with a dividend yield of 2.5%. The double-take would be understandable since at the time of the initial $20 investment, the quote was 5%. Why the difference in rates? The 2.5% yield rate for ABC Inc. could be as a result of an increase in the share price to say, $40. As the stock increases in value the yield falls unless the actual payout increases proportionally. Above all, an investor is locked into the dividend rate that is taken on at the time of making their investment.
Why and When Does Yield Become Important?
Yield is important under two broad scenarios. The first is at the early stages of an investor’s decision about her or her reward. Investors interested in capital growth may not even consider yield, but for the investor that want’s a short term or medium term reward for putting up cash, yield is very important. This is where the hot debate comes from regarding value and dividend investors. So-called value investors take the long-term view, often sitting on their investments for decades before they see any real appreciation of their initial investment.
Dividend yields also become very important in the periods of slow or anemic capital growth. This can happen in a slow economy or during a recession. Investors will ordinarily turn to yield in order to plan out their investments with greater certainty since economic instability leads to general instability of the stock market. Yield, then, becomes a strong hedge against rampant volatility and high risk. Yields also take on greater significance as they grow either by sector or by industry. Often specific industries may find that they prosper despite the wider economic climate. When these industries maintain their pace of growth, the investors that bet on them are usually rewarded well through the increase in dividend payouts.
Are There Downsides To Yield?
The downsides to yield, especially dividend yield, is purely one of perspective so there can be no definite answer. If you are big investor like Warren Buffet who values capital growth above everything else, then dividends are not so good. Warren Buffett, in fact, is notorious for holding a pessimistic view of dividends. Buffett cites two main disadvantages of dividends, and as a consequence, dividend yield. The first disadvantage is that different investors may seek different levels of payouts. This can be a nightmare for companies looking to attract a broad pool of capital investments. Finally, Buffett being the true capitalist as he is, doesn’t get excited about the fact that dividend income is taxed. For him this disadvantage acts as a poor feature of dividends in general. Buffet’s bottom line is that nothing trumps capital growth, ever.
But thankfully Warren Buffett hasn’t completely captured the general imagination of the investment public and some very smart investors still rely and believe in dividend and yield. For these investors yield has zero downside insofar as there is a decent and acceptable return.
Of course, no analysis of dividends and yield can alter the fact that investors do change their tastes. For much of the 80s and early 90s yield was a key factor in determining whether a company was worthy of capital injection. That changed with the emergence of tech companies and their built-in capacity for delivering outsized returns. People have watched companies like Google go from $100 a share to $1,000 a share in a relatively short space of time. Still the inducements for capital over yield are drying up and investors can no longer comfortably put their money on the capital growth side of the ledger. As the economy continues to lumber forward, the importance of yield will once again become a party of the general investing discussion. Companies and investors who are most convinced by the yield-driven approach will arguably benefit the most from the changing economic landscape.