Mon. Nov. 19, 2007

Yield on Cost: Measuring for Success *

This article appeared in The Carnival of Personal Finance #128.

If the first step in sucuessfully managing something is to determine the desired outcome (set a goal), then the logical second step is to determine how to measure your progress to ensure you are moving toward your goal. Most investors look at anualized returns and compare it to a benchmark when evaluating their portfolio. Beyond benchmarking an annualized return, there is a great disparity in how investors measure their progress. One of the more interesting metrics I track is Yield on Cost (YOC). It is simply the annual dividend rate times number of shares owned divided by what you paid for the investment (basis).

Many knowledgeable investors are quick to point out that YOC is an irrelevant metric. They argue that current yield is what is meaningful when comparing investments. They are correct in this statement. YOC is entirely specific to the timing of an investment. You can have a different YOC for the same investment purchased at different times on the same day. It is totally determined by the price paid.

If the objective of an income investor is to invest in securities with increasing income over time, the best metric to measure your success in achieving this objective is Yield on Cost. An illustrative example will help. Consider two companies RY and KO. Let’s assume you purchase both companies at their low in 1997 and hold them through 2006.

If you were judging your investments solely on current yield, they would be virtually the same in 2006 at slightly over 3%. However, based on your original investment, the YOC for RY is more than six times that of KO. This occurred while the average dividend growth rate for RY was only double that of KO – now that is the kind of leverage I like!

As an income investor, I would much rather have held RY during this period.

As mentioned in my post Dividend Income vs. MMA, dividend growth is the reason you choose an equity investment over over a safer investment such as a high-yield Money Market Fund. I track YOC because I expect it to grow over time. At the time of this writing I own 28 equity investments in my dividend/income portfolio. The YOC on them is 4.95%. Using my projection model and assuming that I don’t purchase any additional shares in the future, these are the YOCs I would expect to see in the coming years:

  • Now 4.95%
  • 1-yr 5.32%
  • 3-yr 6.23%
  • 5-yr 7.42%
  • 8-yr 9.97%
  • 10-yr 12.41%
  • 15-yr 23.00%
  • 20-yr 46.38%

46% in 20 years – that’s something to get excited about. In reality, I think I can beat that by fine-tuning my portfolio.

For additional information on YOC, I refer you to the article The Magic of Yield on Cost. It was written by the CEO of Realty Income (O). Let me also add that Realty Income produces the most entertaining annual reports I get each year.

What are your thoughts about yield on cost?

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9 Responses to “Yield on Cost: Measuring for Success *”

  1. FinancialJungle says:

    In addition to YOC and current yield, you can also measure yield based on the after-tax capital. For example, if you think your stock AAA is overvalued, and are considering selling it to purchase BBB, you first must calculate how much capital remains after selling AAA.

    Say $100 in AAA is distributing $3. If the embedded capital gain tax is $20, then your yield on after-tax capital is $3/$80 = 3.75%. If BBB is yielding 3.5%, maybe you want to keep AAA even though the current yield is only 3%.

    (I’m assuming both AAA and BBB have identical fundamentals.)

  2. Dividends4Life says:

    FJ: That is an excellent point! So many times we subconsciously forget to consider the tax ramifications. Trading is not free – from many standpoints…

    Best Wishes,

  3. moneygardener says:

    Interesting point on KO vs. RY on YOC. KO kind of got to bubbly valuation in 1997 so I’m assuming it would have been ruled ‘too expensive’ to the cautious eye.

    I have been investing for a short time but my best YOC differential is 0.3% difference with several of my holdings includng RY and BAC.

    I also find this statistic very interesting. It really shows the pace of dividend growth and the pace of share price growth at the same time. I guess in the case of RY vs. KO it shows whether or not dividend growth was paired to share price growth as it was with RY and not KO.

  4. Dividends4Life says:

    KO is currently trading at a significant premium based on my models.

    You have to look at YOC in layers for a single investment. As noted in my Investing Goals post, YOC will be more sensitive to the yields of what I am buying, versus dividend increases in the early years due to the relative size of the purchases versus the portfolio size. When I wrote the YOC article my YOC was 4.95%, and after a couple of purchases it is now 4.88%.

    Comparing today’s yield with YOC for my BAC holdings, it would not look good in total (5.93% yield today vs. 5.39% YOC). However it looks like this if you break it down in layers:

    Date Pur.. Yield@Pur. YOC
    04/22/05… 4.01% … 5.71%
    04/13/06… 4.34% … 5.56%
    01/12/07… 4.15% … 4.75%
    07/05/07… 5.18% … 5.18%

    I love watching that 04/22/05 layer’s yield shoot up!

  5. TheLocoMono says:

    It is simply the annual dividend rate times number of shares owned divided by what you paid for the investment (basis).

    I am a little lost.

    Using your example with RY, am I right in understanding that based on the YOC that RY is better to buy in 2006 than it was in 1997?

    If you bought one share in 1997 and one share in 2006, how does this affect the YOC?

    I suppose I am just trying to figure out if YOC is more of an effective measurement for when to buy if the stock is low and you know the company has a history of raising dividends/consecutive dividend payouts.

  6. Dividends4Life says:

    TheLocoMono: YOC is really a metric that measures dividend yield and dividend growth. In effect it calculates a yield by basis by current annual income. This shws the effect of not only the initial yield, but the compound growth of that yield. That is why some stocks with a low initial yield are better buys than some with a higher yield. My NPV MMA Diff. calculation looks at this over 20 years and discounts it back. The higher the number the better.

    Hope this made some sense.

    Best Wishes,

  7. richT says:

    YOC, a concept I unintentionally used for sometime, is something to be careful with. The YOC on a past purchase can get quite elevated over time causing the investor to miss opportunities to move to higher ‘real yield’ investments. The reality is you must look at today’s yield (dividend/present value) to make sure you are not missing great opportunities because YOC looks so high.

  8. Rhombus says:

    YOC is the only way to measure results. The underlying philosophy is based on replacement of your investment. For base, however, One must take the average cost of all the shares you have purchaSED, each time of purchase add the number of shares to the previous total number and the cost of shares purchased to the total cost invested in that stock then divide the total amount invested by the number of stocks held – this will give you the average cost per share. (I also include the commissions in that cost) Replacement, because you return from dividends is a percentage of your investment to date, the replacementmust at least equal the average return.


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