When investing, the primary objective is to earn the maximum possible returns on the same. This is primarily why individuals hunt for suitable investment avenues that match their risk profile and investment strategy and also deliver attractive returns. To measure how the investments are performing or have performed, the yield metric is used. Let’s understand it in detail.
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What is yield?
In simple terms, yield is defined as the returns that you earn from your investment over a specified period of time. Yield is either measured against the amount that you invested or against the current market value. Yield includes both capital appreciation and dividend income that you receive from your investment.
For instance, if you invest Rs. 100 and get a return of Rs. 120, then the yield would be 20% of your investment.
Return on equity: Highlights
- Yield measures the returns earned from an investment over a specified period
- Different instruments have different types of yields
- Yield to maturity measures the average yield earned from the bond over its tenure
Formula for yield
The formula for calculating yield is as follows –
Yield = (Returns earned / Investment amount) * 100
What does yield tell you?
In simpler terms, high yield means high returns.
So, if the investment generates high-value yields, you are considered to be earning higher returns at lower risks. However, when calculating yield, you should also see if the market value of your investment is falling. A reducing market value is bad even though it can generate higher yields.
Moreover, in the case of stocks, a high yield might indicate that the company is paying higher dividends. This might cause a cash flow problem for the company since a large proportion of its earnings are being distributed as dividends.
However, if the yield is consistent and is rising marginally, it is a good sign. It means that the stock prices are rising in tandem with the company’s valuation and profits.
Types of yields
Different types of investments have different types of yields. Have a look –
- Stocks
The returns that you earn from stock investment are called stock yield. It is calculated by adding both dividend income and gain in the stock price. There is also a concept of yield on cost when concerning stocks. It is calculated as the net cash flow from the stock (dividend and increase in the stock price) divided by the investment cost. The value is then multiplied by 100 to calculate the metric in percentage.
- Bonds
The bond yield is the annual interest you earn from the bond divided by its current market price. Bond yield and bond prices are inversely related. It means that if the bond yield rises, the bond prices fall and vice versa.
High-yield bonds are better if you are a low-risk investor and want the maximum possible returns on your investment. On the other hand, if you are a high-risk investor who trades in bonds, then low-yield bonds are better. High-yield bonds are not for low-risk investors as they inherently have more risks hence the high yield. They are thus also called junk bonds and have ratings below investment grade. they are generally associated with high credit and liquidity risks.
Bond yield and prices can indicate economic growth and inflation.
Bond yield = Coupon amount/Price of the bond
- Coupon
A coupon is the annual interest rate that you get on debt instruments. It is calculated as a percentage of the book value of debt.
- Current yield
Current yield is the current income you earn from a stock. To calculate it, you need to add the increase in the value of the stock, add the dividend, and then divide the value by the current market price.
Current Yield = Annual coupon / Bond price
- Dividend yield
Stocks pay dividend income, which helps measure the dividend yield. The dividend yield is the dividend earned divided by the market price.
Dividend yield =Dividend earned / Market price
Yield to maturity
Yield to maturity is a special concept applicable to bonds and the returns they generate. Usually, when calculating bond yield, the annual return earned from the bond is assessed. However, the returns earned from a bond up to its maturity are calculated under this metric.
Yield to maturity is expressed as the average annual yield from a bond held till maturity. Since bond prices change, this metric helps you assess the true worth of the bond. It helps you decide whether you should invest in the bond or not.
The formula for yield to maturity (YTM) is given below –
YTM = {Annual coupon rate + (Difference between the face value and market value of the bond / Remaining years to maturity)} / {(Face value + market value of the bond) / 2}
For instance, say a bond has a face value of Rs. 100. Its current market value is Rs. 98. The bond is issued for five years. The annual coupon here is calculated as 10% of Rs. 100, which is Rs. 10.
The yield to maturity would be calculated as follows –
YTM = {Rs.10 + (100 – 98 / 5)} / {(100 + 98) /2}
= 10.4 / 99 = 0.1050
= 10.50%
What does yield represent?
The term ‘yield’, meaning the earnings generated on an investment over a specific time frame, can be calculated for different types of instruments. It can be used to find out whether the investment is lucrative enough to generate attractive returns or not.
How to calculate yield?
Yield is usually calculated by dividing the return earned by the investment amount. It is multiplied by 100 to get the metric in a percentage. Alternatively, you can also divide the returns earned by the market value of the investment to assess the current yield.
Example of yield
If an instrument gives Rs. 10 on an investment of Rs. 100, its yield would be calculated as follows –
Yield = Rs.10/Rs.100 * 100 = 10%
If the value of the investment changes, its yield would include the price change.
Conclusion
Yield, in general, measures the return on investment. It is an important metric when dealing with stocks, bonds and more. So, when investing, assess the yield of the instrument. Compare this yield against the yield generated by instruments in the same asset class. Then choose to invest in an avenue that offers high yields so that you can earn maximum returns.
