I fell in love with the power of dividends in 2011 while working on an income investing newsletter. I very quickly understood the math that makes dividends one of the most powerful tools for investors.
Dividends give you an extra stream of income without taking on a second job. Finding the best stocks requires some upfront effort, of course. But once you own the shares, that money keeps coming in like clockwork.
That is only half of the story.
They are also a powerful tool to build wealth. If you don’t need the dividend income today you can reinvest it into more shares. When the next payment rolls around, you’ll get dividends on your initial shares and the additional shares bought with dividends. It’s the magic of compounding—dubbed by Albert Einstein as the 8th wonder of the world.
Whether your goal is income today or wealth tomorrow, there’s one number that tells you how hard your dividends are working for you—yield.
What’s Under the Hood
The percentage yield is your money’s horsepower. It lets you compare your investments against other income products.
The formula to calculate yield is simple:
A company can pay its dividend monthly, quarterly, semi-annually, or annually. That’s why it makes sense to annualize the dividend for the calculation.
Notice the formula uses your entry price and not the current share price as the divisor. The result is the effective yield specific to your investment.
Keep in mind that your effective yield will probably differ from each day’s reported yield due to changes in the share price. This is the current yield based on the most recent dividend payment and latest share price.
Let’s look at one of my favorite pipeline companies as an example.
A quick Google search shows Enterprise Products Partners has a 6.69% yield. It is calculated by dividing the annualized dividend of $2.18 by the last closing price of $32.61.
Had you bought shares of EPD when I mentioned them in the August 29, 2023, issue of Dividend Digest, your entry price would have been around $26.81. That would make your effective yield 8.1%, much higher than today’s current yield.
Both numbers are simple to calculate and help you make better investment decisions. You want to compare current yields if you have cash ready to deploy. It doesn’t matter that you locked in 8.1% on EPD years ago. If you want to add to your position today, the current yield measures how hard that new money will work for you.
Knowing your effective yield helps you compare it to new opportunities to make sure your existing investments are still outperforming new investments. If that’s not the case, you can make an informed decision to close a position and redeploy your money into a better opportunity.
Knowing the yield of your investments can be used for comparisons to more than just other dividend stocks. You can compare yields against savings accounts, CDs, money market accounts, or even bonds.
This afternoon, all eyes will be on the FOMC. It’s the last opportunity for an interest rate cut in 2025. If you are a borrower, you don’t mind seeing lower rates that trickle through to mortgages, car notes, and credit cards. But lower rates also mean lower yields on the bank products I mentioned above.
Over the past few years, the yields on CDs have fallen. If that trend continues, investors will be drawn more and more to big, boring, safe dividend stocks with higher yields.
Whatever happens with interest rates it won’t affect us. We look for and own stocks with good yields and rising dividends. And even if you aren’t a “math person,” you have a simple formula that prepares you to get the most horsepower out of your money.
For more income, now and in the future,
Kelly Green
