What it is:
How it works (Example):
The formula for dividend yield is:
For example, let's assume you own 500 shares of Company XYZ, which pays $1.10 per share in annual dividends. If the current stock price is $12.00, then using the formula above we can calculate that the dividend yield on Company XYZ stock is:
$1.10 / $12.00 = .0916 = 9.2%
Note that there is an inverse relationship between yield and stock price. For example, if the stock price rose to $15, the yield would be $1.10/$15 or 7.3%. The 500 share investment would be worth $7,500 (vs. $6,000 originally) but the yield on the investment would fall from 9.2% to 7.3%.
Further note that the dividend stays the same, meaning even though the stock price falls (or rises), you still receive $1.10 per share (unless the company changes the dividend).
Why it Matters:
A security's dividend yield can also be a sign of the stability of a company and often supports a firm's share price. Normally, only profitable companies pay out dividends. Therefore, investors often view companies that have paid out significant dividends for an extended period of time as "safer" investments. Thus, should events occur which are detrimental to the share price, the allure of the dividend combined with the stability of the company can support the price somewhat.