2-5 How to Read Dividends
A page sorting out the difference between dividend yield, yield on cost, and payout ratio
2-4 established that a dividend is one form of shareholder return. Next: how should you read it? The figure that catches the eye first is dividend yield. A high yield looks attractive, but stopping there makes it easy to misjudge. Start by separating what the yield is measured against and whether the dividend looks sustainable.
- Dividend yield is
current dividend per share ÷ current share price. - Yield on cost is
current dividend per share ÷ your own average purchase price. - Dividend yield and yield on cost use different bases and answer different questions.
- A high dividend yield can simply mean the share price has fallen.
- Check EPS when looking at profit and FCF when looking at cash, then compare them against dividends paid.
1. Dividend yield is measured against "today's share price"
Dividend yield is current dividend per share ÷ current share price. It tells you how much dividend you could expect relative to today's price if you bought the share today.
In the example, the share price in year 10 is ¥50,000 and the annual dividend is ¥715. If you bought one share today, the dividend yield is 715 ÷ 50,000, about 1.4%. What you are looking at here is how much dividend there is relative to the current price.
The thing to watch is that dividend yield also moves with the share price. With the dividend unchanged, a falling price makes the yield look higher. So a high yield does not necessarily mean the company is in good shape.
2. Yield on cost is measured against "your own buy price"
Someone who already holds the share may instead look at current dividend per share ÷ their own average purchase price. This is called yield on cost, and it shows how much dividend you are now receiving relative to the money you originally put in.
In the same diagram, Investor A bought one share at ¥10,000 in year 1. With a year-10 annual dividend of ¥715, A's yield on cost is 715 ÷ 10,000, about 7.2%. Compared with Investor B buying at ¥50,000 in year 10, the same ¥715 dividend looks very different relative to what each of them originally invested.
Both figures are correct, but they measure different things. Dividend yield is the figure for someone buying now. Yield on cost is for someone who already holds, looking back against their own buy price. When deciding whether to buy, look at the current dividend yield first — not yield on cost.
3. When looking at a high yield, look at profit and cash too
Search for shares and you will find plenty of companies with high dividend yields. Say the same industry contains Company A on a 2% yield and Company B on 10%. A pays ¥100 on a ¥5,000 share price; B pays ¥100 on a ¥1,000 share price. The dividend amount is identical, but because the prices differ the yields differ greatly.
Which one is the right buy cannot be settled on yield alone. What to look at first is whether there is enough profit and cash to support that dividend.
For profit, use EPS. EPS is earnings per share, and placing it beside dividend per share (DPS) shows how well that year's profit covers the dividend. Dividing DPS by EPS gives the payout ratio, which tells you what share of profit is going to dividends.
For cash, use FCF (free cash flow). FCF is what remains from the cash the business generated after the investment it needs. EPS and DPS are per-share figures, whereas FCF measures the company's overall cash headroom — so compare it against total dividends paid across the whole company.
Company A, even on a 2% dividend yield, has earnings per share (EPS) of ¥250 against dividend per share (DPS) of ¥100. Its payout ratio is 40%. Company-wide, total dividends are ¥8.0bn against FCF of ¥20.0bn. When FCF has room above total dividends, it is reasonable to think there is capacity to keep paying even if the headline yield is low.
Company B, on a 10% dividend yield, has earnings per share of only ¥50 against dividend per share of ¥100. Its payout ratio is 200%. And if total dividends across the company are ¥4.0bn while FCF is only ¥2.0bn, it is paying out more than the business left behind in cash. Cash on hand can bridge that temporarily, but if the same state persists, keeping the current dividend will become a strain.
So EPS shows the relationship with profit, and FCF shows cash headroom. When the payout ratio exceeds 100% and total dividends also exceed FCF, as with Company B, the dividend may be stretched on both profit and cash. That said, profit can look small in a one-off year, so rather than judging on a single year, check whether it looks likely to continue next year and beyond.
A dividend is one of a share's returns, but buying because the yield is high puts the order backwards. First separate out which basis the yield was calculated on. Then, looking at profit and cash, check whether this dividend can continue comfortably next year and beyond.
That is the end of Chapter 2. Next, on to Chapter 3 — Understand Mutual Funds.