There are many ways to evaluate a stock. Among the most popular are valuation tools to arrive at some method of comparing one company with another or with an industrial sector. This is often called fundamental analysis.
You may like a company for its products or its slick marketing or the prestige of owning its products, but these are not, in and of themselves, good reasons to buy the stock. They may, however, be good reasons to consider the stock for further evaluation.
With so many stocks to choose from, investors in the stock market need a way to analyze and compare companies. You may find two or more companies in the same industrial sector that look like possible investment candidates. Part of the process of selecting stocks for investment include comparing companies using valuation tools.
Yield-based valuation tools often use the stock's price and some measure of financial performance such as sales or, one of the most popular, dividends. Stock investors need to look at more than one number or ratio before making a decision, however yield-based calculations are popular because they give you an idea of what you are buying.
If you think about it, this makes good sense. When you buy a stock, what are you buying and what does it cost? For stock investors interested in dividends, you must answer the question: what am I getting for the per share price I pay.
Companies that pay strong, consistent dividends are considered by many to be great stocks to own, even if their stock price does not soar. When the stock market is very volatile (prices way up one day and way down the next), companies that maintain a consistent dividend can be very attractive.
For example, utility stocks are known for their history of paying solid dividends. Investors looking for current income or income in a retirement account often look to utility stocks.
One of the ways you can gauge how cheap or expensive a utility's dividend might be is using the dividend yield calculation. The dividend yield is among the many items reported on almost any Website that follows stocks. You can usually find it by looking in the financial ratios area of the company's financial profile.
The dividend yield measures what percentage of a stock's price is being paid out in dividends. The current per-share price is divided into the annual dividend per share. The resulting percentage is the dividend yield. For example, if a company pays an annual per-share dividend of $4 and the current stock price is $64 per share, the dividend yield is 6.25 percent. 4/64 = 0.0625
Now suppose you found another company in the same industry that paid an annual dividend of $4, but its stock price was only $52. Which is the better buy of the $4 annual dividend? Do the dividend yield calculation and see what happens. Clearly, the less expensive stock (with the same dividend) offers a better dividend yield (4/52 = 7.7 percent).
Which of these companies (all else being equal) is the best buy for the same dividend? You can use dividend yield in stock screening programs as a way to help you narrow your search. For example, if you go to MorningStar.com in the "stocks" section, you can use their free stock screen (you have to register) and screen stocks for dividend yield.
If dividends are important to your financial goals (and they should be), you can identify potential investment candidates and compare various candidates.
Of course, the dividend yield changes every time the stock's price changes or the dividend changes. You are primarily concerned with the dividend yield at the time you buy the stock, because that is when actual money is involved. If the price of the stock goes up while the dividend remains constant, the yield will drop. However, you are profiting from a rising stock price.
Once you have bought the stock, the dividend yield becomes less important because you locked in that yield when you bought the stock. If you want to consider adding to your position, then the current dividend yield again becomes important.
A big part of fundamental analysis is relating financial markers to the stock price, just like we did with dividends. This does not give you the complete picture. It does offer a way to not only evaluate the stock, but compare it to another stock.