Yield Calculation: Current vs. Effective

The way stock dividend yields are calculated is simple. As defined in thebuttonwoodproject glossary of terms: Yield is the income return on an investment. In this blog it will be the dividends received from a security and expressed annually as a percentage based on the investment’s current market value. Example: Verizon Communications, at Friday’s closing price of \$50.20 and paying a quarterly dividend of \$.53 per share (\$2.12/year) will have a current yield of 4.2% (\$2.12 divided by \$50.20).  The key word here is “current”. The yield is accurate for new investors evaluating the stock and whether or not a new position is worth the risk at today’s valuation and fits within the scope of an individual’s investment goals. However, there is another calculation that should not be ignored: The Effective Yield. What happens when a company raises (or even maintains) its dividends on stock you already own, but the price has risen considerably over time? As the stock price and dividend rises proportionately, the current yield will stay pretty much the same for new investors, but the “effective” yield, based on an original investment, would be higher.  For example:

Let’s say that you bought 100 shares of income candidate DuPont on the day it was introduced into the blog about three years ago at \$47.00 per share. Your cost basis would be \$4,700.00. At that time the shares yielded 3.49% on an annual dividend of \$1.64 or \$164.00 to you for your 100 shares (\$164.00 divided by \$4,700.00 = 3.49%). Now let’s look at the all important effective yield and how it would have changed for you over the last 3 years.  Friday’s closing price of the stock is \$62.00 and today’s annualized yield is just 2.96% on a dividend of \$1.80 per share (\$180 divided by \$6,200 = 2.96% for 100 shares). But your investment was only \$4,700.00 and the current dividend of \$1.80 per share would now equate to an effective rate of return of 3.83% on your original investment (\$180 divided by \$4,700.00), or 87 basis points higher. This means you’re receiving much better than the 2.96% yield that someone buying today is getting. This return excludes the 32% stock price increase providing another 10.7% in capital gains per year. But even if the price remained at \$47.00 over the three years, your effective dividend yield would still be 3.83%, and not today’s 2.96%. So at the end of the 3 years of holding DuPont, your total annual return is actually closer to 13.8% (10.7% from the share price increase plus about 3.1% from the average annual dividend return over that time). The bottom line is if you hold onto a stock that pays and increases dividends you’re actually getting a better dividend rate of return than people who buy today. Of course, conversely, if the share price were to drop from the purchase price, as did Intel Corp., then your effective yield will be less attractive than today’s current yield.

Below is a chart of the income portfolio’s choices with today’s current dividend and annualized yield and the effective yield if purchased on the day it was introduction into the list.