Before understanding the importance of this measure in the evaluation of a stock, we'll first understand dividend yield. The financial ratio measures the extent of cash dividend paid relative to the market price of the stock per share and then multiplying the factor with 100.
A company, with its stock market price of say Rs. 100, declares a dividend of say Rs. 10 per share then the dividend yield will be computed as 10/100*100 =10%
High dividend yield simply means that the company pays out significantly from its share of profits to its shareholders.
During volatile times, such stocks are a good investment option with reasonably good pay-out. Such stocks are suitable for investors who are risk-averse.
Relevance of dividend yield in stock selection
In case of companies paying out high dividend, they do not retain much of the profits for further investments and instead distribute it to their shareholders. These are generally referred as income stocks in stock market parlance.
Suitable for retirees or risk averse investor class
While valuation of the stock is one parameter looked at, dividend yield should be another concern for individuals looking at a steady income source and averse to risk. Primarily, PSU stocks are known to offer good dividend yield over time.
Nonetheless, when giving heed to this criterion of stock selection, you need to keep the following facets into consideration:
Company growth prospects: Just going by the high dividend yield will not be a sound call from an investor's perspective as you also need to consider the growth prospects of the company as well as industry to which it belongs. More weightage should be given to growth and other dimension of the stock such as management of the company, competitiveness as well as its track record, ratios such as PE, debt-equity should be given heed to besides return on capital employed.
Price appreciation or performance of the stock needs to be checked too: As with falling price, investors may have the fake idea of an increase in dividend yield, price check or its analysis is crucial. This is because with the decrease in share price, dividend yield pushes higher. So, as a cautious stance one must go by this need also, as there may be a case when the company offers high dividend yield and has a steady running business but due to some of the factors may trend decline in price. It is to be noted that dividend yield is calculated based on the historically paid out cash dividends.
Sustainable dividend: Dividend payout history for say last 5 or 10 years must be recorded to infer whether or not the company has been paying out dividends on a regular basis. And so the stocks with irregular pay-outs should be avoided.
Also, investors should overlook one-off special dividends as they can at certain occasions raise the yield to a considerable high which can appear to be enticing. Instead, investors can look it as the time when the company sees no foreseeable opportunities to invest its corpus and hence has resorted to declaring sizeable dividends.