The Other Yield
What Is Yield On Cost?
When investing in dividends, an important idea is “yield on cost.” If you’ve never heard this phrase before, it is OK, but it is terribly important to understand. Yield on cost is basically a short way to say: “The current return you are getting on a security compared to the initial cost you paid for it.” If this sounds confusing, then please continue reading because it is an easy concept to understand, but just a bit wordy to explain.
Yield On Cost Example
Let’s consider the following scenario: You purchase a stock for $10.00 that pays a 3% annual dividend ($0.30). That means you will be getting ~$0.075 each quarter. After a year, let’s say that the stock price appreciates to $12.00 after a year.
Well, the company had a great year, and in the interest of attracting investors, they decide that they want to raise the dividend to $0.36 a year to make it 3% again (remember, the stock price is now $12.00 so the dividend of $0.30 is now 2.5% rather than 3%). The dividend is now $0.36 each year! Great, so now you are earning 3% again, right? WRONG!
Don’t forget, you bought the stock for $10.00, not $12.00! So you are now getting a dividend of $0.36 on $10.00 or 3.6%. What does this mean? Your yield on cost is 3.6%! Now, any stocks you purchase at $12.00 will be earning 3% dividends, but any that you had purchased at $10.00 are now earning a whopping 3.6%. This is why yield on cost is so important, and this is why the current yield of a stock isn’t very important in the long run compared to companies that are constantly raising their dividends. Eventually, your yield on cost will obliterate any current yield you can find on a stock.
Companies That Can Afford To Pay
The other beautiful thing about yield on cost is that the good companies that you invest in with this methodology are the ones that tend to have low payout ratios. What this means is that the money the company is paying out as dividends does not represent a huge percentage of their earnings, which tends to be a problem with high yielding dividend stocks. It will take a while for your yield on cost to be competitive with high yield stocks, but that is healthy, and the stability cannot be matched.
The next time you are eyeing a high yield dividend stock, consider these things:
- Can the company afford to consistently pay out this dividend?
- Does the company have a history of lowering dividends?
- Does the company have a history of keeping dividend growth stagnant?
- Will the payout ratio prevent the company from growing competitively?
- Will the payout ratio force the company’s hand in making unpopular decisions?
Shift Gears & Avoid Neutral, Dividends Should Grow
There are a lot of companies out there with high dividend yields, but fail some of the questions above. A good example is Verizon (VZ). Verizon has a high yield at ~6.5% but their history indicates that they had kept their dividends stagnant for nearly ten years! Does this make Verizon a bad play? We don’t think Verizon is a bad company at all, but we do believe that a yield on cost approach to dividend investing will outperform them over a ten-year cycle, especially if they keep their dividend flat.
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That was a very informative post! I never thought of dividends in that way before. Of course, the way the market has been going, my dividend yield is probably plummeting!
I do know that one thing I need to do is purchase more dividend stocks for my portfolio. Might be good to act soon on this dip… Thanks for making me think.
Interesting, however, you also have to consider the opportunity cost:
For example, if you buy a stock at $10, it is now $20, the yield is $2, then that is 20% on cost but 10% on the current price.
However, let’s say you can buy another stock for $20 which has a yield of $3. Your yield on cost will only be 15%, so it’s 5% lower, but your overall yield will actually be better.
You make a good point about companies that constantly raise their dividends versus ones that don’t! That is certainly something to watch for (though you would also expect it to be factored into the stock price).
What do you think?
Hi Kevin,
Thanks for dropping in! I agree with what you say. In the short run, high yield will beat out the yield on cost approach, but over the long run (assuming consistent investment) the yield on cost with a growing dividend will beat out the high yield. This is of course assuming that the stock prices appreciate.
High yield dividends are a short run method to maximize immediate return, but a stock who’s dividend increases consistently will eventually win out on a longer timeline. A good example to look at is the Dividend Aristocrat’s Index which is strong list of Dividend stocks that have consistently raised their dividend over the last 25 years.
If you played any of those stocks consistently for that span of time against a high yield dividend payer (without cherry picking buy/sell dates) then I’m willing to bet you’d come out with a much larger yield than any high yield dividend payer that didn’t raise dividends consistently. Thank you for your excellent insights.
Thanks,
Timothy
Wealth Artisan Team Member
http://WealthArtisan.com
I agree 100% on the importance of the subject, however (there´s always a however) I do also agree with Kevin in a sense.
If a stock is not as good as it was before, you have to be cautious not to think in the lenses of yield on cost, or you risk not selling if for a better option. Yield on cost is nothing more than compound interest.
Two companies can have the same yield on cost, one being a growth stock and another a dividend stock.
That´s my two cents. And hello from Brasil! =)
Hi Rodolfo,
I absolutely agree that valuation is never a one time thing. Yield on cost is kind of like compound interest, but here is a better way to think of it. Reinvesting dividends is the compounding interest, the Yield on cost approach is like your interest rate continually inching up. If you combine dividend reinvestment along with Yield on cost, then you’ve got something far more powerful than just your basic compound interest. Thanks for stopping in!
Thanks,
Timothy