Forward dividend yield refers to the projection of a company’s yearly dividend. It’s calculated as a percentage of the current share price. For many investors, the dividends paid out by companies are one of their primary sources of income, with another being an appreciation in the stock price. When stock prices decrease, dividends serve as a reliable revenue stream.
To determine the amount of dividend investors will receive, companies often consider past and forecasted dividends. And this is what brings us to the two types of dividends: forward dividends and trailing dividends.
Understanding Dividend Yields
Companies share their net profits with investors in the form of dividends, but they need to be approved by the board of directors first. Thus, even if a company has earned a huge amount of profits in a given period, the board must approve any dividend payouts. Dividends can be paid out at any time, but are most commonly paid either annually or quarterly.
Younger companies typically retain more of their earnings to reinvest to grow their business, and may not pay out any dividends at all, whereas established firms may pay out a considerable portion of their net income in the form of dividends.
How to Calculate Dividend Yields
Investors and analysts employ a particular formula for calculating dividend yield. Here is an example to illustrate the difference between forward dividends and trailing dividends:
Consider Company ABC, whose current stock price is $50. Let’s assume that the company made the following dividend payments in the past year:
March: $0.50 per share
June: $0.50 per share
September: $0.50 per share
December: $1 per share
In total, ABC Company paid out $2.50 in dividends for each share in the past year.
To calculate the trailing dividend payment, divide the total dividend by the stock price and multiply the result by 100: ($2.50 / $50) *100 = 5%.
However, not all companies use the technique above to calculate dividend yield. Some instead use a forward dividend yield calculation.
Contrary to the trailing method, the forward dividend yield method estimates dividend payments for the coming 12 months. Due to its nature, it is best employed in situations where the dividend payments can be forecast with reasonable accuracy.
In the example of Company ABC, the latest payment was $1 per share. If the company’s quarterly payout were to remain constant, it would distribute total dividends of $4.00 per share in the next year. This means the forward dividend yield would be calculated as follows: ($4 / $50) *100 = 8%.
Significance of Dividend Yields
To show the relevance of dividend yields, consider two companies, Y and Z. Company Y’s share price is $20, and it pays yearly dividends of $1 for each share. Company Z’s stock price is $40, and it also pays a yearly dividend of $1 per share.
The dividend yield for:
Company Y = ($1/$20)*100% = 5%
Company Z = ($1/$40)*100 = 2.5%
Given the two cases above, an investor interested in dividend income would likely opt for Company Y’s stock since it pays twice the percentage amount in dividends, as compared to Company Z. If Company Y’s stock price rises to the same price as Company Z stock, then investors in Company Y would receive substantially more money in dividends than Company Z investors do.
High dividend yields often make a company more attractive to investors. However, they limit the growth potential of a company. This is because every dollar that is paid out in dividends represents money that is not being used to reinvest, grow, and expand the company.
When to Use Forward and Trailing Dividend Yields
When the dividend payments made in the course of a year differ significantly, the most sensible approach to use is the trailing dividend yield. In contrast, if the company plans to use a regular dividend payout for the next 12 months, the forward dividend yield is a more accurate metric to use.
Forward dividend yields represent the projected payment that is to be paid out in a given time period in the future. It’s used by investors to calculate returns for a particular stock or portfolio of stocks. To compute the forward dividend yield, analysts take the latest quarterly dividend then annualize it to reflect a full year’s payment. The result is then divided by the stock price.
The abovementioned method of calculating dividends is different from the trailing dividend approach. The latter involves computing the total dividends paid out in the course of the previous year, then dividing that sum by the stock price.
Since dividend amounts often do not change much, the absolute dollar amount of the dividend yield is mainly affected by changes in the stock price.
Large, well-established companies tend to pay higher dividends than smaller, newer firms.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
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