The dividend yield of a share is fairly easy to understand. It is the current dividend per share divided by the current share price. So a company with a current dividend per share of 4p, and a share price of 100p, has a dividend yield of 4%.
If the company paying the dividend is successful, then its profits and dividends will grow over time. If the dividend grows by 5% per year for ten years, then it will have risen to 6.5p by the end of year ten. As a result, if you bought the shares at 100p ten years ago, then your yield on cost would now be 6.5% (6.5/100) – in other words, it tells you the dividend return as a percentage of the price that you paid for the shares.
This measure is worth bearing in mind if you are investing for income. You might be able to buy a company bond that is paying an interest rate of 5% today, or you might be able to buy its shares with a dividend yield of 3.5%, which is expected to grow at 10% per year. The income from the bond is higher at first, but it will stay the same for the life of the bond.
If you buy the share instead, you’ll have a lower yield at first, but after four years of 10% dividend growth the share will be paying a higher income on cost than the bond (though this ignores the risk of disappointments).