When you begin looking into the strategy of dividend growth investing, there will be a lot of unfamiliar terms you see quite often. One of those terms that many dividend growth investors refer to is yield on cost.
2 Types of Dividend Yields
With dividends, there are two different kinds of yield often referred to. The most common is current yield. This is simply the current dividend yield. It is calculated by taking the annual dividend amount paid by a company and dividing by the current stock price of the company. For example if a company pays out $1.00 in dividends for the year and the current stock price is $25.00, then the current dividend yield is 4% (1/25 = 0.04). If in 10 years I still own this stock, and it now pays out $2.75 a year in dividends while current stock price is $55.00 then I have a current yield of 5% (2.75/55 = 0.05). This is the yield that many investors will first look at to determine if they are interested in purchasing that stock. Most dividend growth investors will have a required minimum current yield required before considering a company for investment. Personally I look for current yields over 2.5% but on occasion I may consider something slightly lower.
The less common type of yield but also frequently used in dividend growth investing is called the yield on cost. Yield on cost is more a measure over time as the company you own increases it’s annual dividend amounts. For example, if I purchased the stock referred to above for $25.00 a share with a current dividend of $1.00 I have a current yield of 4%. Next year I hope that company increases it’s dividend payment. So if the company increases it’s dividend payment next year to say $1.10, then my yield on cost is 4.4%. This is calculated by taking the current dividend amount dividend by the original price I paid for the stock. Current price probably has increased, but I am using the original cost I paid. So in this example I take $1.10/$25 = 0.044 or 4.4%. If I still own the stock in 10 years and the company has continued to increase it’s dividend payment, my yield on cost will have increased each year they increase the dividend payment. So if in 10 years the company is paying $2.75 in dividends then my yield on cost is 11% (2.75/25 = 0.11).
Yield on Cost vs. Current Yield
You will hear arguments among dividend growth investors about which yield metric is the most important. I will always believe the current yield is the most important metric. Current yield is always most important because it tells me how much I am earning on the current amount of capital I have invested in the company. I can compare that current yield to other companies to determine if they are still paying me enough to stay invested. If income was important to me, I might consider selling a stock that has a current yield of 2.5% and reinvesting in a stock that has a higher 5% yield. This would then instantly pay me more income. This is why current yield is the more important measure, because it tells me how much current income I can earn from my capital and helps me compare if I could earn more current income in a different investment.
Why do I care about yield on cost?
Since I said current yield is the most important measure, you may wonder why we even care about yield on cost then. The reason is because yield on cost is a good measure of how successful our investment choices are. As dividend growth investors, our goal is to own companies that annually increase their dividend payments at a rate higher than inflation. As companies increase their dividend payments, yield on cost will increase. If I own a couple different companies for say 10 years, and each company had a yield of 3% when I first invested in it, the one with the higher yield on cost now has been the most successful for me in terms of dividend increases.
Yield on Cost Isn’t Important
In my opinion though, yield on cost really isn’t that important to keep track of. It’s interesting to know what your yield on cost is, but it shouldn’t be affecting any of your buy or sell decisions. Those decisions should always be based on what is currently happening with the company. I may have purchased ABC stock 15 years ago for a great price that is now paying me a yield on cost of 20% with a current yield of 3%. ABC has done a great job for me increasing their dividend payments. However, my current decisions need to be based on what ABC is currently doing. If lately management has seemed reluctant to increase dividends as much, I may want to consider looking at another company. If lately I am more concerned about earning income to live off of, I may want to look for a company with a higher current yield because they will pay me more current income. Yield on cost should not matter to me in those investment decisions.
While I believe yield on cost can be an interesting metric to keep track of, the truth is it just isn’t that important of a metric. Current yield is always more important because it tells me the amount of income I can receive from the current amount of capital I currently have. Instead of worrying about yield on cost, it is much better to pay attention to the current yield you are being paid along with your unrealized gains. Also make sure you are keeping track that the companies you own continue to annually increase their dividend payments at a rate higher than inflation. If you focus on these things then you will do fairly well towards your investing financial goals.
What do you think? Is yield on cost that important for dividend investors?
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