Reprinted with the permission of the American Association of Individual Investors (AAII)

Yield is a term that is used quite often in the investment universe. But it is frequently a source of investor confusion.

The problem is that “yield” has many different meanings, and thus many different implications for investors.

The basic dilemma is that yield may or may not be synonymous with total return-the bottom line for investors.

What It Is

The term “yield,” on its own, is an imprecise term that can mean any number of things-ranging, for instance, from:

• A security’s annual percentage rate of return, to
• The annual income from an investment as a percentage of the price at a particular point in time (for example, the current price).

The more precise definition of yield becomes apparent when a qualifier is used-for instance, dividend yield, current yield, or yield to maturity.

How It Can Be Used

Investors who seek an income component from their investments often look at various yields to indicate which investments will provide a higher amount of their return in the form of annual income payments. Thus, for example, income-seeking investors may prefer a stock with a higher dividend yield than one with a lower dividend yield.

Yields also can be used to indicate the relative risk of different securities. Typically, securities with higher risk must offer higher yields to compensate for the greater risk. Thus, for example, dividend-paying stocks whose firms are having financial troubles will tend to have higher dividend yields than the stocks of financially secure firms, and the bonds of companies with lower credit ratings will have higher current yields than those with higher credit ratings.

How It Can Be Misused

Yield is also sometimes used to indicate a security’s total return. However, it is important for investors to understand the difference between “total return” and most uses of the term “yield.” The bottom line for any investor, for any investment, is total return.

Total return incorporates capital gains and losses, as well as any annual income thrown off by the investment in the form of dividends or interest payments.

Total return is also specific to the individual investor’s particular experience-the purchase price paid for the investment, the holding period, the sales price, and the actual income payments received. Most uses of the term “yield” refer only to the income component and do not include a gain or loss component.

Investors-particularly those individuals who are interested in bonds-sometimes make the mistake of equating quoted yields with total return. However, most quoted bond yields ignore gains or losses in the market value of the bonds, an important component of total return even in a bond holding. Although there is one bond yield measure, as we shall see, that comes close to the total return concept (yield to maturity), it is only an estimate of total return based on assumptions that may or may not apply to the individual investor who has purchased the bond.

Yields for Stock Investors

Dividend Yield

A dividend yield is calculated by dividing the indicated annual dividend (the expected dividend for the next four quarters) by the closing price of the stock. It simply provides the historical annual dividend relative to the current market price in percentage form.

How is it useful?

When compared to other dividend yields measured over the same time period, it tells you the annual income you can expect from this stock relative to other stocks: If you invested today at the current price, you will receive more annual income as a percentage of your original investment from a stock with a higher dividend yield than one with a lower dividend yield. The higher dividend yield also indicates there is a greater risk that dividends may be reduced or not paid in the future. Dividend yield reflects only income, and does not take into consideration gains or losses.

Yields for Bond Investors

Current Yield

A bond’s current yield is calculated by dividing the annual interest payment by the current market price of the bond. Like a dividend yield, it only captures one aspect of total return-the income generated by the investment. It ignores any changes in value from gains or losses.

How is it useful?

The current yield will tell you how much interest income you will receive each year from the bond relative to the price you are paying for the bond, assuming you were purchasing it today at the bond’s current price.

Coupon Yield

A bond’s coupon yield is the simple interest paid by a bond annually as a percentage of maturity value. The coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued.

How is it useful?

The coupon yield tells how much income you will receive each year you own the bond, expressed as a percentage of the maturity value of the bond. For example, a bond that is issued with a $1,000 value at maturity and a 4.5% coupon yield will pay $45 in annual interest payments.

This amount is figured as a percentage of the bond’s maturity value and will not change during the lifespan of the bond, regardless of how the price of the bond fluctuates in the secondary markets. This is unlike the bond’s current yield, which fluctuates based on the bond’s current market price.

Yield to Maturity

A bond’s yield to maturity is one yield figure that comes close to a total rate of return concept. However, it makes a number of assumptions. It assumes that the bond is held to maturity, and that all interest payments are reinvested at a rate that is equivalent to the yield to maturity.

Yield to maturity comes close to the total return concept because it takes into account all possible sources of income from a bond, including coupon income, earnings on reinvested income, and capital gains or losses due to the difference between the price paid when the bond was purchased and the return of principal at maturity.

However, it is not a return you will actually receive on a bond, but a rate of return you could expect to receive if you held the bond to maturity and were able to reinvest all income at the yield-to-maturity rate. Your actual return will be determined by a number of factors, including whether you actually do reinvest income, the actual rate of return you receive on any reinvested income, and the difference between the price you paid originally and your selling price (if you sell before it matures) or the value at maturity.

How is it useful?

Yield-to-maturity quotes are useful because they allow you to compare different kinds of bonds-those with dissimilar coupon yields, bonds selling at a discount or premium, and different maturities. For example, how do you compare a 20-year zero-coupon bond that provides no annual income payments but is purchased at a deep discount to its value at maturity, with a 15-year bond that has a 6% coupon yield and is selling at a premium to its maturity value? Looking at the current yield to maturity of the two bonds allows you to make an apples-to-apples comparison of their relative “expected” rates of return. But remember, you would only receive the “expected” rates of return if all of the assumptions held true-you held the bond to maturity, and were able to reinvest all income at the same rate as the yield to maturity.

Yields for Muni Bond Investors

Taxable-Equivalent Yield

The taxable-equivalent yield is the yield on a taxable bond (or taxable bond mutual fund) that would result in the same after-federal-tax yield to an investor as a given tax-exempt bond (or tax-exempt bond mutual fund). It is calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form).

How is it useful?

The bottom line for taxable investors is not just total return, but total return after taxes. This yield is useful for high tax bracket investors who may receive a higher aftertax rate of return by investing in tax-exempt municipal bonds rather than taxable bonds. It is used to compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher aftertax yield.

Yields for Mutual Fund Investors

30-Day SEC Yield

A yield quoted by bond mutual funds, the 30-day SEC yield is calculated according to a formula determined by the Securities and Exchange Commission (SEC). It is primarily a snapshot of the interest distributions from the fund over the prior 30 days, with some adjustments.

How is it useful?

The 30-day SEC yield is a standardized yield calculation for bond funds that allows investors to compare the yield performance of one bond fund to another. However, the figure is a reflection of the past 30 days and is not necessarily an indication of future yield.

In addition, the calculation implies the bonds will be held until maturity, and in practice bonds funds tend to trade actively and do not hold bonds to maturity. For this reason, a mutual fund’s income yield (see below) may be a better measure of a bond fund’s income-generating potential.

Yield

A mutual fund’s yield is the per share annual income distribution (which could include interest, dividends and short-term gains net of expenses) made by a mutual fund, divided by its year-ending net asset value, plus any capital gains distributions made during the year.

How is it useful?

This yield is similar to a dividend yield and would be higher for income-oriented stock funds and lower for growth-oriented stock funds.

The figure only reflects income-it is not total return. The yield also may be distorted if the fund reports short-term capital gains as income.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

http://www.aaii.com/

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

I thought this was a finance 101 topic but based upon what I read in the financial press maybe it’s not. For some reason people like dividends. Even I have fallen prey to the siren song of dividends, as the fact that Bank of America (BAC) now has a 5.2% dividend yield with a P/E ratio of 9.84 excites me. My perverse logic works something like this: the stock can’t go much lower and you’re practically guaranteed a 5.4% return on your money, which management wouldn’t be paying out if they didn’t think they could support it – so it must be a good investment. But the reality is that I was making this argument when the stock was at 55 and today it closed at 48.59. That’s a 12% drop. Nevertheless, over the last 5 years Bank of America has been a pretty good investment – but not necessarily because they have a high dividend.

From talking to people I get the impression that there are several misconceptions out there that need to be cleared up. First, let’s be clear that dividends are not a free lunch. Every time a stock goes ex-dividend the price of that stock goes down by a corresponding amount. The reason is simple: the company’s value has gone down by the amount of the dividend payment. It has less cash in the bank. Second, and related to the first point, higher dividends do not necessarily translate into a higher total stock return. When companies pay out dividends either 1) they are making a conscious decision to trade off future growth for a return of capital or 2) they are raising additional funds from one group of investors to transfer funds to another group of investors. In principle, all a company can do is tweak the balance between dividend return and capital gain return.

If you don’t find these arguments convincing you can review the academic work that has been done on this topic. Perhaps the best-known study was the 1961 paper by Miller and Modigliani [1]. Their mathematical proof, which is now generally accepted as correct, basically demonstrates the assertions made above. In addition, a 1974 Black and Scholes study proved empirically that high dividend stocks produced no better total return than lower dividend paying stocks [2]. The bottom line is that dividends just don’t matter – one way or the other.

Although there are a number of arguments in favor of paying dividends…

• Signaling effect – because a company is very reluctant to lower a dividend (it’s a really bad sign) they are equally cautious in raising a dividend. They only raise the dividend if they truly believe that the business has bright prospects.
• Desire for current income – some people, for example retired people, like to receive current income to fund their living expenses. (I never have understood this since for a few dollars they can sell some of their investments to generate cash for living expenses.)
• Clientele effect – some investors like dividends and do not suffer negative tax consequences from receiving them – e.g. pension funds, IRAs, endowments. By paying dividends a company is appealing to this target group.

…there are other arguments against high payouts that are even more compelling:

• Tax issues – it used to be the case, and in all likelihood it will soon be the case again, that dividends were taxed at a higher rate than capital gains. Therefore, by paying a dividend a company is forcing their investors to pay taxes.
• Creates a reinvestment burden – now that I have this dividend what do I do with it?
• Calls into question the company’s prospects for growth. The assumption is that if a company is paying a dividend they must not have very good investment opportunities. Typically, high growth companies don’t pay dividends because they have better uses for the capital.
• If a company has excess cash they can repurchase shares instead of paying dividends. This will drive up the price of the stock and return cash only to those shareholders that want it.

Despite all the evidence that dividends don’t matter the financial community loves to flap their jaws about the virtues of dividends. S&P even maintains a list of “dividend aristocrats” which are stocks that have upped their dividends for 25 or more consecutive years. When Lowes declared a quarterly dividend of eight cents per share and an increase in their share repurchase on May 25, 2007 everyone pointed out that the dividend represented a 60% increase and that they had paid a cash dividend each quarter since going public in 1961. Lowe’s CEO made the statement: “The additional share repurchase authorization and dividend increase are an indication of Lowe’s financial strength, and reflect our commitment to return capital to shareholders.” Apparently the signaling value of dividend increases isn’t so obvious because CEOs always spell it out for us.

Then there was this June 13, 2007 article in Forbes that begins with:

 

“Wednesday was one of those days Caterpillar investors can use to take their wives out to dinner. They got a large dividend increase, as well as a message of confidence from the company.

 

The board of directors of Caterpillar (nyse: CAT - news - people ) voted Wednesday to increase the quarterly cash dividend by 20%, or 6 cents, to 36 cents per share.

 

“This increase reflects the board of directors’ continued confidence in Caterpillar’s long-term outlook,” said CEO Jim Owens

Investors responded by sending shares up $1.85, or 2.4%, to $79.93.”

I found the assumptions in this article strange to say the least: 1) All Caterpillar investors are men 2) I should spend a return of capital and 3) Caterpillar’s stock price responded to the dividend increase as opposed to “the directors’ continued confidence”.

Even more blatant dividend propaganda was forced upon us with the May 21, 2007 Barron’s cover story entitled “Still Too Stingy”, which called for a return to good old fashioned dividends as an alternative to share repurchases. The article laments the fact that dividend payouts are on the decline and points out that millions of baby boomers are nearing retirement and seeking higher yields. The article has several particularly annoying quotes from Edward von der Linde, the manager of the Lord Abbett Mid-Cap Value fund, “Shareholders own the company. The earnings are their cash. Give it back.” Regarding the potential for an increase in federal dividend taxes, he says “Since when is my tax status the business of management?” and he argues that share repurchases “give money to people who want to go away. Why not give the money to all shareholders equitably? The only way that the board of directors and management can directly affect shareholders is via the dividend.” [3]

I just don’t understand this point of view. I own a company’s stock because I want to be invested in that company. I don’t want them returning a portion of my investment on a periodic basis. When they do that I have to reinvest the money and they involuntarily trigger tax consequences, which company management should be concerned about. Let’s face it, one of America’s best-loved stocks, Berkshire Hathaway, has never paid a dividend and no one is complaining. Conversely, even the Barron’s article points out that initiating a dividend payment has not helped Microsoft’s stockholders.

I will concede one point to the dividend payment camp that was actually raised in the Barron’s article. There are several examples of companies buying back their shares at inflated market prices that are ultimately not sustained. To avoid this problem companies need to be judicious about when they buy back their stock. Of course, it’s hard to imagine a CEO announcing that they are going to discontinue their stock repurchase program because they believe that their stock is overvalued.

December 12, 2007 Addition

I just read another Barron’s article [4] about stock buybacks that further supported this last point with some very compelling data. In the graph to the left Standard & Poor did an analysis that showed that the more aggressive a company was in repurchasing their shares the worse their stock performance was. Aggressiveness was calculated as the percentage of a company’s market capitalization that was repurchased. Part of the problem is that the more aggressive companies borrowed heavily to support their repurchase programs. It’s possible that companies that used excess cash to execute these repurchases faired much better, but that was not discussed in the article.

[1] M. H. Miller and F. Modigliani, “Dividend Policy, Growth, and the Valuation of Shares”, Journal of Business, Volume 34, pp. 411 – 433, October, 1961
[2] F. Black and M. S. Scholes, “The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns”, Journal of Financial Economics, Volume 1, pp. 1 – 22, May, 1974
[3] Andrew Bary, “Still Too Stingy”, May 21, 2007, Barron’s
[4] J. R. Brandstrader, [$$]“Buybacks That Bite Back“, December 10, 2007, Barron’s

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.