The Dividend Yield in Financial Modeling and Valuation

Dividend Yield Definition: The Dividend Yield is a common metric for investors and financial analysts that measures a company’s annual dividends against the stock’s current price. It indicates how much you’ll earn over the next year, in cash, for each $1.00 you spend buying the company’s shares (a yield of 5% means you’ll earn $0.05 on this $1.00).

“Dividends” represent a company’s cash distributions to its shareholders when they have extra cash left after paying to run the business, re-invest, and expand; some investors view Dividends very favorably and invest based on them.

Dividends and the Dividend Yield tend to be extremely important in some industries, such as commercial banking and power & utilities, and insignificant in others, such as early-stage tech startups.

The Dividend Yield Formula

The Dividend Yield formula is simple: Dividends per Share divided by the Current Share Price.

You could also calculate it based on the company’s total Dividends and current Market Capitalization, or Equity Value, if you do not have the per-share figures:

Investors who aim to earn income from their stocks in addition to capital appreciation (i.e., the stock price going up) care a lot about this metric.

How Do You Calculate the Dividend Yield in Real Life?

Using Coca-Cola’s 2022 annual report data as an example:

Closing Price at 2022 Year-End = $63.61

Annual Dividends per Share for 2023 = $1.84

Dividend Yield = $1.84 / $63.61 = 2.89%

So, if you had purchased Coca Cola’s stock at the end of 2022 and held it for all of 2023, you would have earned a 2.89% Dividend Yield on it.

If you had invested $1,000, therefore, you would have earned $28.90 in income on your investment over the entire year.

For firms with consistent dividends, a higher Dividend Yield can indicate more substantial returns for shareholders, making the company an attractive target in mergers and acquisitions – as long as its cash flow can support those dividends.

In industries such as power & utilities, commercial banking, and insurance, the Dividend Yield and related methodologies such as the Dividend Discount Model can determine valuations and be major negotiation factors in deals.

Dividend Yield vs. Dividend Payout Ratio

The Dividend Yield measures how much you earn by buying a company’s stock, while the Dividend Payout Ratio tells you how much income the company is distributing to its shareholders.

The Dividend Payout Ratio is calculated as follows:

A company’s “Net Income” equals how much it has earned, after taxes, counting all its revenue and expenses.

Net Income = Revenue – Cost of Goods Sold – Operating Expenses – Net Interest Expense – Other Expenses – Taxes

In the Coca-Cola example above, the company’s Net Income for 2022 was $9.5 billion, and it issued a total of $7.6 billion in Dividends.

Therefore, its Dividend Payout Ratio was $7.6 billion / $9.5 billion = 80%.

This is a very high Dividend Payout Ratio – above what most other, similar companies offer.

This could be a positive sign if the company has enough cash flow to sustain these types of payouts, but it could also be a negative sign if it means the company has less cash to re-invest and fund future growth.

With both the Dividend Yield and the Dividend Payout Ratio, the most important point isn’t their absolute levels, but their sustainability and how the company compares to others on these metrics.

Evaluating both can give you a clearer picture of a company’s financial wherewithal and valuation in certain industries.

How Do You Use the Dividend Yield in Models and Valuations?

While many financial metrics directly shape valuations, the Dividend Yield isn’t a direct driver in most financial models.

Instead, it serves as a comparative metric, letting investors know the attractiveness of one investment over another, depending on their cash flows and uses of cash.

For instance, an investor or analyst evaluating different banks might use the Dividend Yield to understand which institution is potentially offering a superior return on investment. A higher yield can indicate a more attractive dividend policy or an undervalued stock, which could be lucrative for potential investors.

However, context is king. While a favorable Dividend Yield can make a stock look appealing, you need to consider it in the full context of the industry and the comparable companies.

For example, a Dividend Yield that’s too high might indicate the company is overpromising and may not have sustainable capital allocation policies.

In an industry like commercial banking, a Dividend Yield that’s overly high could mean the bank might need to shore up its regulatory capital as a “buffer” against unexpected losses, which could hurt its valuation.

Final Thoughts on the Dividend Yield

The Dividend Yield is a metric whose usefulness varies widely by industry.

It’s rarely a direct driver, except for specialized cases such as the Dividend Discount Model, but it is a useful comparative metric for banks, insurance firms, power/utility companies, and any other industries in which companies issue consistent dividends.

In those industries, it can tell you which companies are operating more or less efficiently and which management teams have more or less generous policies toward their shareholders.