It is no hidden secret that the stock market is a great place to build a corpus. Conservative, prudent investments can help you create wealth gradually. Many people invest in this market, not only to create a corpus but also to ensure that they can have a steady source of income. An excellent way to ensure that you can create a regular and steady income stream is to invest in companies offering dividends. However, most people are confused about the difference between dividend rate and dividend yield. Read on to find out the difference between the two terms.
Dividend rate vs dividend yield – the differences
The best way to understand the difference between dividend rate and yield is to start with their definitions. They are as under:
Dividend rate: Dividend rate, often plainly referred to as dividend, is essentially the total expected dividend payment that you can get form a specific investment, which could be a stock, a mutual fund or another such money market instrument. Dividends are typically paid either quarterly or on an annual basis. The dividend rate could be fixed or adjustable, and it generally depends on the preferences and strategies followed by the company offering the dividend. The board of directors of the company offering this bonus determines the dividend rate, which is then approved by shareholders.
Dividend yield: Dividend yield is simply the financial ratio that demonstrates how much a particular company is paying in dividends, each year about its stock price. The dividend yield is generally expressed in percentage and represents an estimation of the dividend-specific return of an investment. As mentioned above the dividend rate can either remain the same as the previous financial year, or it could increase or decrease. In case the dividend amount remains unchanged, the yield will rise when the stock price falls. Conversely, the yield will fall in case the stock price rises. Since the dividend yield changes with the stock price, it may often appear unusually high, especially for those stocks, which are falling quickly.
Example to help understand the difference between dividend rate and dividend yield
Let’s say you invest Rs.100,000 in XYZ Bank, for which you are allotted 1000 share units. Now, the bank declares dividends of Rs.5 per share, which is the dividend rate. In such a situation, you will receive a total dividend amount of Rs.5,000. In this situation, your dividend yield can be calculated as below:
Rs.5,000 x 100/100000 = 5 per cent
Book closure and ex-dividend aspects of dividend rate vs yield
While the formula mentioned above applies to investments held for an entire financial year, you have to consider the yield ratio for shorter investments, based on the stock’s book closure. For instance, if XYZ Bank’s book closure is on 1st July, and you purchased your shares on 1st January, you would be eligible for a 10% yield, since the shareholding period is only six months, as opposed to a year.
Apart from the book closure, it would help if you also considered the ex-dividend aspect, which is the date after which you will not be eligible to receive dividends in a given financial year. Thus, if XYZ Bank announces 25th July as book closure, the stock exchange may declare 20th July as the ex-dividend date, after which you will stop receiving dividends from the company.
Factors Impacting Dividend Rate
Some companies announce dividends regularly, and these stocks can be an investor’s favourite. If you wish to invest in dividend stocks, it is important to understand the factors responsible for framing the dividend policy of a company.
Profitability and cash flow: To pay regular dividends, the company must generate continuous profit and maintain a healthy cash flow. The amount of profit the company earns also influences the dividend amount. Higher profitability and ample cash flow will ensure the company can distribute dividends to its shareholders.
Growth plan and investment needs: Companies that need significant investment to maintain growth momentum may choose to retain earnings instead of distributing dividends. When companies reinvest profits into expanding operations and research, they aim to drive future growth and enhance shareholders’ value.
Financial stability: When a company is financially stable, it can adopt a sustainable dividend policy. Factors such as low debt levels, high liquidity, and steady earnings growth instil confidence in investors and support sustainable dividend payments.
Dividend payment history: A company with a history of dividend payments will maintain a steady dividend rate for its future dividend payments because it satisfies shareholders and increases the company’s reputation.
Factors Impacting The Yield
Dividend yield tells investors how much the company is paying as a dividend compared to the current market value per share. A company’s dividend yield policy is shaped by factors such as earnings, payout ratio, market conditions, capital structure, and growth prospects. By understanding these factors, investors can evaluate dividend-paying stocks more efficiently.
Dividend policy: A consistent and stable dividend policy will result in a higher dividend yield. The dividend policy is a strategic decision made by the company’s management, considering various internal and external factors.
Payout ratio: A payout ratio refers to the portion of net income the company pays out in dividends. A higher payout ratio implies a larger portion of earnings being paid out as dividends and less being retained for reinvestment and growth.
Financial performance: A company’s dividend yield policy is closely related to its earnings and cash flow. Higher profitability and cash flow allow for larger dividend yields.
Capital structure and debt level: A company’s capital structure and debt level affect its financial flexibility. A company with a higher debt level may face constraints in distributing dividends due to its debt obligations.
Rate of interest: The rate of interest in the economy impacts the dividend yield ratio. In situations like lower interest rates, investors look for alternative sources to earn higher returns. This increases the demand for dividend stocks but reduces the dividend yield per share.
What is a company’s dividend policy?
A dividend policy is a strategic decision taken by the company’s board and management that shapes the company’s dividend payment structure. Simply put, it outlines how a company distributes its dividends, including rates, frequency, etc.
What are the factors that determine the dividend rate?
The following factors determine the dividend rate:
- Cash flow
- Financial stability
- Growth plans and future investment requirements
- Dividend payment history
What is the significance of the dividend yield?
Dividend yield helps investors assess the income-generating potential of a company. A higher dividend yield suggests higher income from investment in terms of dividend earnings.
What is the difference between dividend rate and dividend yield?
The dividend yield is the percentage of the company’s current share price paid as dividends over the years. Conversely, the dividend rate is the amount of cash the company gives its shareholders per share. Understanding dividend rate vs dividend yield is necessary for better decision-making.
Can a high dividend yield be a risk?
Yes, a high dividend yield can indicate a significant decline in a company’s share price due to financial trouble and market conditions. It is important to assess the company’s overall financial health and perform a comprehensive analysis before investing.