Yield: Not too hot, not too cold

Yield can mean different things: To give up or surrender; A measure of agricultural production; That big yellow sign you missed before slamming into another vehicle.

Most people know those definitions of yield. But do you know the difference between dividend yield and earnings yield, or between current yield and yield to maturity? Judging by some of the reader e-mails we receive at Investor Clinic, there's a fair bit of confusion about yield.

That's not surprising, because yield has a multitude of meanings in the investing world.

So today, we'll explain some of the most common usages of the term. Don't yield to the temptation to ignore this article. Reading to the end could yield substantial benefits.

Dividend yield

One of the most-discussed types of yield, dividend yield is the annual dividend paid by a company, divided by the stock price. The result is expressed as a percentage.

For example, pipeline operator Enbridge Inc. pays annual dividends of $1.70 a share. Its stock closed yesterday at $49.74. Its dividend yield is therefore $1.70 divided by $49.74, or 3.4 per cent.

The dividend yield is always changing. When the stock price goes up, the dividend yield goes down (assuming the dividend itself doesn't change). When the stock price falls, the dividend yield rises.

Like Goldilocks, dividend investors usually look for a yield that's not too hot and not too cold. If a yield is too high, it may signal that the dividend is vulnerable to being cut. If it's too low, investors who want income won't be interested. At Investor Clinic, we like our dividend yields to be somewhere between 3 and 6 per cent, but that's just us; there are no hard and fast rules.

Earnings yield

Take the annual earnings per share of a company. Now divide it by the share price. Presto: That's your earnings yield.

The earnings yield shows how much profit a company generates relative to the price investors are willing to pay for its shares. The higher the earnings yield, the better.

Consider Shoppers Drug Mart Corp., which posted a profit of $2.69 a share for the fiscal year ended Jan. 2. Yesterday, its stock closed at $38.23, so its earnings yield is $2.69/$38.23, or about 7 per cent. Notice that Shoppers' earnings yield is a lot higher than its dividend yield of 2.3 per cent, because Shoppers pays out only a portion of its earnings as dividends.

Warren Buffett is known to be a fan of earnings yield. When evaluating a stock, he compares the earnings yield to the yield on U.S. Treasury bonds. The earnings yield is usually several points higher than the Treasury yield to compensate for the additional risk of owning a stock.

Here's a great party trick: If you flip the earnings yield on its head - that is, divide the stock price by the earnings per share - you get another common valuation measure: The price-to-earnings ratio.

Free cash flow yield

Free cash flow is an important measure, because it shows how much cash a company has after paying all of its bills and reinvesting in its business. Free cash flow can be used to pay dividends, buy back shares, pay down debt or make a big bust of the CEO to display in the lobby.

To calculate the free cash flow yield, take the free cash flow per share and divide it by the share price. The higher the yield, the more cash the business is generating relative to its share price. Some investors consider free cash flow yield a more accurate valuation measure than earnings yield, because the former accounts for capital expenditures whereas the latter does not.

As a general rule of thumb, some investors like to see a free cash flow yield of at least 10 per cent before they invest.

Yield to maturity

When you see a bond yield quoted, it usually refers to the yield to maturity. This is the total return an investor can expect, including interest payments and any capital gain or loss, if he or she holds the bond until it matures. It's also known as the bond's internal rate of return.

Bear in mind: The yield to maturity assumes that all interest payments are reinvested at current interest rates, which usually doesn't happen because rates are always changing. So the investor's actual yield to maturity may be higher or lower depending on whether rates rise or fall.

It's also important to distinguish between a bond's coupon rate and its yield to maturity. Consider a Province of Ontario bond with a coupon of 4.75 per cent and a maturity date of June 2, 2013. My discount broker was quoting this bond yesterday at a price of $106.699.

Because the investor will get only $100 in face value at maturity, he or she will be taking a hit on the principal portion of the bond, and that capital loss will offset a good chunk of the 4.75 per cent in annual coupon interest. Result: The bond's yield to maturity will be about 2.5 per cent - 2.25 percentage points less than the coupon.

Current yield

Many investors are fooled into thinking they're earning higher returns on bonds than they actually are. This is particularly true of bond exchange-traded funds. Consider the iShares CDN Bond Index Fund . According to GlobeInvestor.com, the yield on this diversified ETF is an enticing 4.4 per cent.

Sorry folks, but that's what's known as the current yield. In other words, it's the amount of interest paid over the past year, divided by the current price of the ETF. It doesn't account for the fact that, as in the example above, the bonds in the portfolio are trading at a premium and will gradually decline to par value as the maturity date approaches.

If you want a better measure of the return expected from a bond ETF, look at the weighted average yield to maturity, which here is 3.4 per cent. (You can find this information on the ishares.ca website).

We can't help with your driving. But now that you have a better understanding of yield, you can navigate the investing world with greater confidence.