What Is Yield?
Yield refers to the earnings you make on an investment over a specific period of time. It is expressed as a percentage based on the amount you invested, the current market value, or the face value of the security. Yield includes the interest you earn or dividends you receive from holding a particular security. Depending on the valuation of the security, yields may be classified as known or anticipated.
Understanding the Formula for Yield
Yield is a measure of the cash flow you receive on your investment. It is usually calculated annually, but quarterly and monthly yields are also commonly used. Yield should not be confused with total return, which is a more comprehensive measure of your return on investment. The formula for calculating yield is:
Yield = Net Realized Return / Principal Amount
Imagine your parents offer to buy you an apartment under one condition: You get a roommate and charge enough rent so the apartment produces income rather than costs your parents’ money. Assume your parents pay $250,000 for the apartment and tell you they want a 5% yield.
Let’s say you find a roommate and charge her $2,000 in rent. Is that enough to produce the yield your parents want? To calculate the yield for real estate, you need to know the cost of the property and the net rental income (rent minus expenses, such as taxes). If your parents tell you they pay $3,000 a year for taxes and other expenses, the net rental income is ($2000 * 12) – $3000 = $21,000. Divide that number by the real estate value of $250,000, then multiply by 100 to get a net yield of 8.4%. This more than meets your parents’ demands.
What Yield Can Tell You
A higher yield indicates that you can recover more cash flow from your investments, which is often seen as a sign of lower risk and higher income. However, it’s important to understand the calculations involved. A high yield may be the result of a declining market value, which artificially increases the calculated yield value even when the security’s valuations are decreasing.
While many investors prefer dividend payments from stocks, it’s also important to keep an eye on yields. If yields become too high, it may indicate that either the stock price is falling or the company is paying high dividends. Higher dividends could mean the company’s earnings are increasing, which could lead to higher stock prices. Higher dividends with higher stock prices should result in a consistent or marginal rise in yield. However, a significant increase in yield without a rise in the stock price may indicate that the company is paying dividends without increasing earnings, which could signal near-term cash flow problems.
Types of Yields
Yields can vary depending on the type of investment, the duration of the investment, and the return amount.
Yield on Stocks: For stock-based investments, there are two types of yields commonly used. The yield based on the purchase price is called yield on cost (YOC). It is calculated by dividing the price increase plus dividends paid by the purchase price. Many investors prefer to calculate the yield based on the current market price, known as the current yield. It is calculated by dividing the price increase plus dividends paid by the current price.
Yield on Bonds: The yield on bonds that pay annual interest can be calculated using the nominal yield. This is calculated by dividing the annual interest earned by the face value of the bond. However, the yield of a floating interest rate bond or an index-linked bond will change over time based on the applicable interest rate or fluctuations in the index value.
Yield to Maturity: Yield to maturity (YTM) is a measure of the total return expected on a bond each year if you hold the bond until maturity. It differs from nominal yield as YTM remains constant throughout the holding period.
Yield to Worst: Yield to worst (YTW) is a measure of the lowest potential yield that can be received on a bond without the possibility of the issuer defaulting. It ensures that certain income requirements will still be met even in the worst scenarios.
Yield to Call: Yield to call (YTC) is a measure linked to callable bonds. It refers to the bond’s yield at the time of its call date, taking into account the bond’s interest payments, market price, and duration until the call date.
Tax-Equivalent Yield: Municipal bonds have a tax-equivalent yield (TEY), which represents the pretax yield a taxable bond needs to have in order to match the yield of a tax-free municipal bond. TEY is determined by the investor’s tax bracket.
Calculating Yields and Variations
While there are various ways to calculate different types of yields, companies, issuers, and fund managers have the freedom to calculate, report, and advertise yields according to their own conventions. Regulators like the Securities and Exchange Commission (SEC) have introduced a standard measure for calculating yields, known as the SEC yield, to ensure fairer comparisons of bond funds. Mutual fund yield represents the net income return of a mutual fund and is calculated by dividing the annual income distribution payment by the value of the mutual fund’s shares.
Yield can also be calculated for any business venture, measuring the return generated on the invested capital.