Understanding Dividend Yield for Retirees

Dividends are a popular topic for many investors who are looking for ways to generate income and support themselves in retirement. Often, retirement investors who focus on dividends will consider a particular stock’s dividend yield when deciding whether to purchase it. Stocks with higher dividend yields pay larger dividends relative to the amount invested, which is exactly what these investors are looking for.

Understanding what dividends are, what they aren’t and what dividend yield means, will help you decide how they may fit into your retirement income plan.

Cash dividends are payments made to company shareholders. The source of this money is the issuing corporation’s net profit. Since stock represents ownership in the company, shareholders are entitled to their respective share of the company profits, and dividends are one way for them to receive it.

However, a key element that is often overlooked is that dividends are not anything other than a return of capital that belongs to you anyway. Companies can either choose to reinvest earnings to increase business value (which belongs to the shareholders) or pay them out as dividends.

Dividends are not “extra” cash, according to an article from the Chicago Booth Review. You can see this very directly in the way that a stock’s price adjusts when dividends are paid. Suppose you hold a $25 stock. If that stock pays a $1 dividend, then its price will fall by $1 when the dividend is paid. You’ll be holding $1 in cash and a stock that is worth $24.

Dividend yield is calculated by dividing the annual dividend by the stock’s price per share. For example, if a company pays a $1.50 annual dividend and has a $75 stock price, then it has a dividend yield of 2%.

Dividend yields are important because they allow you to compare the dividend payments of two companies whose stock prices differ. So, if you want to compare the $75 stock that pays a $1.50 dividend to a $40 stock that pays a $1 dividend, then you simply need to compute the dividend yield for both.

The $40 stock has a 2.5% dividend yield, so it is better from the perspective of a dividend investor, assuming all other characteristics are equal. You get more dividend per dollar invested in that stock.

When thinking about dividend yield, it may be tempting to focus only on the dividend. However, that is only half of the equation. Because it is a ratio, dividend yield is affected by both changes in the amount of each dividend paid, as well as changes in the stock’s price.

While dividend investors generally consider higher dividend yields to be a good thing, beware that a rising dividend yield could be the result of a falling stock price. At the same time, a falling dividend yield can be the result of a rising stock price. It would be important to consider those price changes and what it means for the dividend yield.

Dividend investing is often applauded as a safe way to generate stable income in retirement, but there are some risks associated with this strategy. This isn’t to say that dividends or the stocks that pay them are bad, but misunderstanding can lead to misuse.

Dividend-paying stocks often derive from very good companies, which is why they can pay the dividend in the first place. However, over-reliance on dividends for an income stream isn’t as safe as it may seem.

The technical benefits of dividend yield as income for retirees are largely overplayed or misunderstood, but that doesn’t mean there is no benefit to dividends at all. After all, dividends are real, and the cash does come to you. It can be very comforting to see cash dividends hit your account.

Dividends are also an important component of total return, but this implies that dividends are reinvested — not spent.

Dividend payout decisions are up to each corporation, but there are some general distinctions between the types of stocks that pay dividends and those that don’t.

Dividend-paying stocks are typically those of larger, mature companies with a strong and reliable history. Their size and success are what give them the ability to pay dividends, although not all these stocks — called “blue chip” or value stocks — do.

Stocks that don’t pay dividends tend to be smaller, younger and growth oriented. These companies may not have sufficient earnings to pay dividends yet or they may be choosing to reinvest that capital to drive further growth. However, there are also stocks that fit this profile that do pay dividends.