Today I wanted to cover one of the most critical dividend stock metrics, yield on cost (YOC for short).
Rising YOC is one of the great benefits of owning dividend stocks, in particular one with good dividend growth. YOC is simply the current dividend rate divided by the price you paid for the stock. For example, if you bought a stock for $20 with a 5% yield ($1), and the dividend over time rose to $2, then your yield on cost would be $2/$20 or 10%. In other words, the return on your investment is rising over time! How many other investments can give you that kind of benefit? A dividend stock with zero dividend growth, while still better than one with no dividend, would never have an increasing YOC.
I’ll let the CEO of one of the great dividend companies explain it. Tom Lewis is CEO of Realty Income, ‘The Monthly Dividend Company’. He explains Yield on Cost here in some more detail. Read the whole thing for yourself. Here is a teaser,
A new income investment paradigm, therefore, is to find investments that pay high quality, increasing income, and keep them as long as they continue to produce a rising yield on cost over time. Once you’ve “got” this lesson, you’ll not only receive an A in the class, but you’ll also be able to build and maintain an income portfolio that is designed to last a lifetime.
Imagine buying a portfolio of dividend stocks, with 4% avg yield, and ten years later (with a 7.2% dividend growth rate), you’re making 8% on your original investment and ten years later you’re making 16% on your investment! And that is irrespective of the market price of the stock. This is one of the truly great powers of dividend growth investing. In can make you very rich over time.
Now, just a few more details. Many dividend investors, like myself, reinvest their dividends every time they get them. This complicates the YOC calculation a bit but not by much. With reinvested dividends the YOC is the current dividend divided by your weighted average cost basis. Every time you reinvest your dividend you have a new purchase price for those new shares which combined with your original purchases gives you a weighted average. Details on how to calculate this in detail can be found here. In general, as long as your dividend is increasing, your YOC will increase even with reinvested dividends.
So, while you’re searching for great high quality dividend stocks make sure to keep YOC in mind, in other words, make sure you balance current yield with solid dividend growth, and a rising YOC will help make your retirement a very bright one.
6 Comments
David Fleischer · October 25, 2010 at 9:48 am
Paul,
I used to always select the option to reinvest my dividends… until I got burned with stocks that plummeted and I realized that I would have been better off pocketing the dividends.
I also own some Altria and the stock has done well. My question is, how do you decide when to stop the automatic “reinvest dividends” on stocks that have made major moves up? Do you ever deselect the option for a few quarters until the stock corrects and then start up again?
David
libertatemamo · October 25, 2010 at 10:48 am
David, great question. Dividend re-investing is a point of some controversy among dividend investors. My default position is always to re-invest the dividends as long as the company is executing and the fundamentals look good. This means that at times I’m re-investing dividends while the stock is over-valued, but its tough to make that call on a quarter to quarter basis. So, I usually wait until fundamentals start to deteriorate which often shows up in non-rising dividends first, then if I change my opinion then I get out all together. So, I guess in short, I never just pocket the dividends. The power of re-investing dividends is just too great.
Other dividend investors, pool up their dividends every quarter and invest them in the best investment at the time, e.g. the most undervalued stock they like at that time. Sounds good in theory but I think it exposes the investor to too much behavioral biases. Its tough enough to pick the right investment every once in a while, its another thing to do it multiple times every quarter. I try to limit my decisions to a few big ones every once in a while.
Question for you; what happened to those stocks that plummeted, did they come roaring back after the recovery started or did they stay down? Were they bad investments or just temporarily mis-priced?
Investing is a lot about getting the odds in your favor as much as possible. You really never know what is going to happen next.
BTW. Altria is an incredible investment.
Sorry for the book of a response.
David Fleischer · October 25, 2010 at 11:50 am
Paul,
First, no apologies needed on the length of your response. I learned a lot just reading it and appreciate the time you took to write it.
As for my stock that plummeted, the biggest one, and perhaps the only real sore point, is GE. I had it in my portfolio for 10+ years and all that time I was reinvesting the dividends anywhere from the 30s up to the $70s or more. Now it is at $16. I know that this might be an extreme case but in looking back at it, I would have been better to not reinvest… or to have sold out of the stock sooner! Duh.
And yes, I like Altria too. Sometimes I have a morale issue of investing in tobacco but some how the I get over it every time I get the dividend!
David
libertatemamo · October 25, 2010 at 5:02 pm
This is the thing about investing. You’ll never be 100% right. If you’re 60-70% right you’ll do just fine. But those 30-40% of the cases can be painful. I try to learn from those as much as I can.
I don’t think the GE case is that extreme. But it is very instructive. With GE you would have been better to sell the stock sooner. But hindsight is easy. GE was/is like a bank, GE Capital almost brought them down. Like most banks, the problem is leverage.
I owned GE and some banks (WFC, BAC) before the financial crisis as well. They had long periods of consistent dividend payouts and increases. Then boom! All the leverage almost killed them. My takeaway from the crisis was not to invest in banks or other companies that are over leveraged and have balance sheets that no one can really understand. That’s probably an extreme response but I’m ok with it.
This brings up the subject of managing risk in a portfolio which I plan to post on soon.
Paul
David Fleischer · October 27, 2010 at 10:48 am
Thanks Paul. That is good advice. I look forward to your next posting…
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