In finance investors have a trade-off between risk and return. The higher the risk, the higher the expected return. This explains why we expect higher returns on shares than on a bank deposit.
There are two types of returns:
1. Dividends
2. Capital Gains
The return on dividends and the capital gains is the total return of a stock.
Dividend Yield: Periodic, discretionary distributions by management to the shareholders on a pro-rata basis.
Formula: Dividend/(Initial share price)
Capital Gain Yield: Changes in the share price.
Formula: (Capital gain)/(Initial share price)
Percentage return: (Capital gain+dividend )/(Initial share price)
Real v nominal Return:
Often returns need to be adjusted for inflation. The fomula used to adjust for inflation is:
1 + real return = (1+Nominal return)/(1+inflation rate)
Example:
On January 1 2009 Builders Co Limited was selling for $4 a share. By December 31 it had a share price of $6. During the year the company paid a dividend of 60cents. What was the dividend yield, capital gain yield and percentage return for the year?
Answer:
Dividend Yield = Dividend/(Initial share price)= 0.6/4.00= 15%
Capital Gain Yield = (Capital gain)/(Initial share price)= (6.00-4.00)/4.00=50%
Percentage return = (Capital gain+dividend )/(Initial share price) = (2.00+0.6 )/4.00 = 65%