I will not sell XYZ as my yield on cost is now 8%
I’m sure you have heard (or even said) this line a few times, haven’t you? Funny enough, I’ve also used this line to justify some of my holdings. For example, I’ve considered the yield on cost for my low dividend paying stocks. The idea is to show how a 1-2% dividend yield stocks could become a 3%+ yielder in a few years. Examples of companies like Disney (DIS) which pay around 1%-1.5% yield, but provide shareholders with a strong pay raise each year. I have held DIS in my portfolio for about 5 years now and it is currently paying 3% yield on my cost.
What does Yield on Cost (YOC) Means?
The yield on cost or the YOC refers to the dividend yield you receive based on the price you initially paid to acquire a share. For example, you purchased shares of Disney (DIS) a while ago at $80 while it was paying an annual dividend of $0.78. Your yield at that time was ($0.78/$80 * 100) 0.975%. Not even 1%…. Most dividend growth investors would disregard such poor yield and search for a better distribution rate.
The point I used to convinced those investors to buy low yielding stocks was based on the yield on cost. Let’s assume you bought DIS at $80 with a dividend of $0.78. Five years later, the stock has jumped to $132 and the dividend is now $1.31. What is your dividend yield? You can answer this questions with two different numbers. The first one would be to use the yield on cost and therefore using the current dividend paid ($1.31) divided by the price you paid to acquired those shares ($80). Suddenly, you have DIS shares paying a 1.64% yield instead of 0.975%. This is what we call the yield on cost.
However, many investors would disagree with you and claim that the DIS yield has barely changed over the past 5 years and is currently 0.992%. This is because those investors use the current dividend paid ($1.31) divided by the current price ($132).
What the YOC hides
Using the yield on cost could become dangerous for your portfolio. I realised this while I wrote a controversial article about General Electric (GE). While my thesis was that GE should not be part of a dividend growth portfolio as it will continue to struggle increasing their payouts, many investors claimed they would never sell it. What was their main argument? Their yield on cost was over 10%.
These investors caught a falling knife back in 2008-2009 while GE ran into severe financial problems due to the credit collapse (no wonder GE sold GE capital recently!). At that time, GE even cut their dividend payouts. Many investors saw an opportunity to grab shares of a giant blue chip for about $10. 8 years later, their investment value has tripled and their yield on cost reached double digits.
I can appreciate the rationale of holding a stock paying 8 to 10% dividend yield. However, what the yield on cost hides in such situations is the present state of affairs. By using the YOC to justify your holding, you use their past performance. Kudos to you if you made a great move, but this doesn’t foresee what will happen next.
What if you get rid of the YOC and start looking at the current yield instead?
Imagine you bought for $10,000 shares of GE during the credit crisis. Let’s say your investment now worth $30,000 and your YOC is 10%. This means your GE shares pay $1,000 annually in dividend. This also means GE current dividend yield is 3.33%.
If you were to sell your shares today, you would receive $30,000, not $10,000. Therefore, you would dispose of $30,000 to generate a payout of $1,000. While finding a company paying a 10% dividend yield is highly difficult, finding one paying 3.33% is far from mission impossible. Even better, chances are you will find a company that has better growth perspective than GE in the next 10 years. For one, I would gladly swap my GE shares for any of the Five Canadian Banks (RY, BNS, CM, BMO, TD) as they all pay over 3.50% and show better growth perspectives.
What really matters… (and it’s not the YOC)
In the end, what really matters for me at the moment is my dividend growth rate. Since I will not use my dividend payout for at least another 30 years, I don’t really mind how much I’m generating with my portfolio today. However, the growth rate tells me how fast I am running in front of inflation each year.
If I was about to retire, the dollar amount generated by my portfolio would become a lot more important. I would then agree that buying new shares of DIS at 1% yield is not very appealing. What would matter to me at this point is how much I receive from my portfolio each month. If the yield isn’t high enough, I would have to compensate by selling part of my holdings to generate enough income.
In both cases, the yield on cost remains irrelevant. At best, I would feel good by looking at my DIS shares paying a 6% yield in 30 years from now, but chances are the company’s current yield will remain around 1%. The YOC shows if you were smart (or lucky) enough to make strong investments in the past. However, it doesn’t tell you anything about what your future yield will look like. I don’t think it should be used to justify any of the holdings in your portfolio. What do you think?
Disclaimer: I hold shares of DIS, RY, BNS, TD, not GE.
I agree that YOC is irrelevant to the future, but I like to think of YOC as a “feel good” statistic. Psychologically, it’s nice to go back 20 years on my bank stocks and say “wow I’m really making 25% YOC on this one”. My CN stock is probably yielding a YOC of about 12%. This is why I keep track of my YOC for my long term holds. Like in anything else, one wants to feel good about its actions!
Hello Michel,
good point, it is probably the most “feel good” metric! hahaha! I must admit I’m glad to see that my DIS now pays me a 3%+ yield and I can’t wait to have my CNR paying 12%!
Cheers,
Mike
I target current yield. Or at least watch for dips where the yield jumps and I can get companies like the ones you mention with a higher entry.
Later,
DFG
DGF,
interesting concept. I’ve noticed many investors look at current yield and watch for drops. I find this strategy a bit risky as sometimes, the yield goes higher for good reasons.
cheers,
Mike
I agree with you 100%. YOC is a fun metric but too many people, including a surprising amount of financial bloggers use it to make buy and hold decisions and like you said, this is exactly the wrong way to use it.
Thanks for helping to educate others
Hey One Dad,
I’ve made that mistake too in the past, but I always work on improving my investing process.
Cheers,
Mike
Not in the least. The future prospects of a business are all that matters, in my opinion.
-Bryan
Hey Bryan,
I agree with you. Unfortunately, it is hard to predict the future some times 😉
cheers,
Mike
Same thinking here… It is a past metric.
It all depends on how you look at it.
I still look at YOC as a measure of lost opportunity. If you compare it to an old investor and a new investor you get the following results (let’s say, both want to invest $1,000 dollars into JNJ):
An old investor bought 17 shares of JNJ @ $58 a share, with initial yield 3% and today that investment would yield him for example 5%.
An old investor would today buy 7 shares @ 130 a share with initial yield of 2.5%.
To reach 5% YOC the new investor would have to wait 5 or more years for him to have that $1000 dollars making him 5% instead of 2.5%
So my 5 years ago 1000 dollars invested makes me 5% while today invested $1000 dollars makes me only 2.5%
And if I decide to sell, yes I make some capital gain, and decide to wait for the correction (which may not come for next few years) and buy back in 3 years later, I will be worse off than today (basically starting all over). Look at it from the perspective of that $1,000 dollar amount (invested then or now)… just my 2c
I view YOC as a forward metric – If I buy $1000 worth of JNJ yielding 3%, and earn $30 today. If it grows dividends at 7%/year, my dividend income will be $60 in a decade. So my yield on cost will be 6% then. So if I need $60/year to retire in 10 years, then this is a good thought exercise to go through.
As far as selling is concerned, I think that it is tough to say in advance whether a company like GE is experiencing short-term turbulence or it really is going downhill. This is why I have embraced the do-nothing mantra to pretty much never sell.
On a side note, I am highly skeptical of claims by others that they have bought at the bottom during the financial crisis. The chances of loading up just once at $8/share and not buying above that low on the way down from $30 or above that low on the way up to $30 is just super low..
I wouldn’t call YOC irrelevant as it can serve a purpose. Any metric used in a vacuum provides data that can be misleading. YOC is generally historical while current yield is the present. Even DGR is based on historical data.
Your example assumes the investment is held in a tax advantaged account. If capital gains were included, a $3,000 tax payment would be due requiring a 3.7% current yield to achieve $1,000 in dividends.
As none of us can foresee the future, multiple metrics should be used for analysis of which one could be YOC. My use of YOC is twofold, 1) to gain a fast sense of potential taxes owed should I sell, and 2) provide a historical sense as to the impact of currency swings on the dividends paid (when translated to US$ from CAD, GBP, AUD, EUR, MXN, HKD, CLP and SGD)