The Yield-on-Cost Equation: The Most Worthwhile Two Minutes An Income Investor Can Spend

The Yield-on-Cost Equation: The Most Worthwhile Two Minutes An Income Investor Can Spend

by Marc Courtenay

Your latest bank statement, no doubt, demonstrated again that our interest-bearing accounts (or money market funds) are paying next to nothing. No wonder higher yielding investments look so tempting.

But no matter how tempting, my days of chasing inflated yields are over. I’ve been burned too many times buying stocks like Freeport-McMoran, Dow Chemical, or Alcoa, only to have them suspend or reduce their dividend payment.

And each time, of course, the stock price sunk.

But a loss isn’t really a loss if you’ve truly learned something… or so goes the old saying.

Two key points here:

  • For starters, don’t be swayed by the current dividend yield and ignore the safety and stability of the investment.
  • And perhaps even more importantly, never overpay for a stock – no matter how high the dividend yield.

In this report , I’ll show you how to avoid both income traps using one simple equation you probably never knew existed…

Yield-on-Cost: Leaving Nothing to Chance

Income investors, like us, must measure success differently than growth and total return investors. And the way we do it is by utilizing an amazingly useful metric called “yield-on-cost.”

The yield-on-cost calculation tells us exactly how much income an investment is paying us from day one.

The formula is very easy to use… Simply divide your current annual dividend (found on Yahoo! Finance) by the original cost you paid for your shares of stock. The result is your yield-on-cost.

Current Annualized Dividend ÷ Original Cost Per Share = Yield-on-Cost.

Pretty basic, right? What it’s telling us, however, is powerful.

This two-minute calculation reveals what our dividend yield is today, based on the price we paid for our original investment. A much more telling number than simply checking the current yield on a stock.

The Yield-on-Cost Equation: A Few Real World Cases…

Let’s see the yield-on-cost equation put to work in an example. Take Realty Income (NYSE: O), a real estate investment trust (REIT) known for steadily increasing its dividend over the last 40 years.

Say you’ve been a shareholder of the REIT for the past 16 years, investing $10,000 at $8.56 a share in 1994. By applying the yield-on-cost equation you can see that your “true yield” is 20% – a lot more than the REIT’s 5.9% current yield.

$1.72 (Current Annualized Dividend) ÷ $8.56 (Original Cost Per Share) = 20%

I chose this particular example for a simple reason: To demonstrate the importance of investing in companies, trusts, or funds that have a long-term reputation for increasing their annual dividend.

Over time, the increases result in a yield that’s far greater than the current yield on our initial investment.

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The example also underscores another key point – when we’re hunting for the next dividend-payer to add to our portfolio, we can’t simply look at the current yield. It’s totally misleading.

Driving Home the Yield-on-Cost Equation

Let me use another, halfway hypothetical example to really drive this point of the yield-on-cost equation home… Say it’s 1994 and you had $10,000 to invest to generate income. You did your research and narrowed it down to Southern Company (NYSE: SO).

At the time, the stock was trading for around $30 per share with a current yield of 3.7%. Plus, it had a history of increasing its dividend.

Your other choice was some newly formed oil and gas producer your cousin Vinny told you about. It had no history of dividend hikes, but its current yield stood at a more robust 7%.

Which should you choose? It’s Southern.

Fast-forward to today and it turns out that oil and gas company never hiked its dividend. You would still be earning 7% interest on your initial investment. On the other hand, Southern increased its dividend like clockwork, almost every year.

Although it was only yielding 3.7% at your entry, thanks to all the dividend increases your true yield (yield-on-cost) now checks-in at just over 11%. Not to mention, in 2001, you received a special one-time 10% dividend when the company spun-off marketing and risk management firm, Mirant.

Granted, this is a simplified and generalized example. But it’s one that plays out in the market year after year.

Investors opt for higher current yields, often in more risky sectors, with no history of dividend hikes. They completely ignore safer companies with lower current yields and a history of dividend hikes. And in the process they end up losing out on income.

So if our objective is to increase income over time, comparing current yields is not enough. We also need to focus on a rising yield-on-cost.

If you’ve never calculated yield-on-cost before, I recommend you do so on the companies you currently own. If it’s increasing over time, and the underlying company fundamentals remain solid, hang tight. Otherwise, it might be time to look elsewhere.

Sleuthing Out Your Own Dividends…

If you want to take over the Captain’s seat yourself, and fly a solo mission for dividend-payers, just be mindful of the following…

  • Whether you’re considering a stock or a fund, always calculate the yield-on-cost.
  • Go to the company’s website or call the Investor Relations department and ask about its dividend-payment history. Ideally, you only want to consider companies with a tradition of raising its dividend, regularly.
  • Dig deep. Ask your broker for all the research they have available. Read analysts’ reports and see for yourself how consistent and generous they’ve been to shareholders.

Stocks with histories of increasing their payouts are more likely to increase your yield-on-cost over time. And once you’ve identified your target, buy only on price dips. Doing so will do wonders to your yield-on-cost.

Once you’re a shareholder, be sure to track the fundamentals. That means reading quarterly and annual reports in an effort to gauge whether you believe the company is likely to continue raising dividends.

Particularly negative developments may put the dividend under pressure. Treat such news as a cue to move on.

Good investing,

Marc Courtenay
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