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I have written about the Yield on Cost (YOC) metric previously in this article, and now I want to explore it further and find a way to make it more useful. YOC is the current dividend divided by the initial price paid. The main criticism of YOC is that it is based on historical data and irrelevant when comparing current yields. Basically, just because YOC is high does not mean that an investor should not switch out to a stock with a higher current yield in order to increase income.

For example, an investor who bought 100 shares of Wal-Mart (NYSE:WMT) back in August of 2011 would have paid about $50 per share. WMT paid annual dividends of $1.46 at that time, making the yield at the time a respectable 2.92%. Since that time, WMT has increased in price to about $71, and now pays out $1.88 per share annually since its last dividend increase. This gives it a current yield of 2.65%, less than the initial yield when the investor purchased the shares. Critics of YOC argue that because the Yield on Cost is at 3.76% ($1.88/$50), the investor may be tempted to hold the stock instead of increasing income by replacing it with a stock currently yielding 3%.

I agree with this assessment, although I believe that it is omitting a key factor in the decision making process. Switching stocks would incur taxes on the capital appreciation, thus reducing the value of the holding (with the exception of tax-free or tax-deferred accounts). All of a sudden, the investor is left with less capital to invest in a different stock. I have recently been using a new metric that I created to help with the decision making process.

Continuing the example above, let's say the investor wanted to increase income by switching out shares of WMT for shares of Coca-Cola (NYSE:KO) because it is currently yielding more at 2.9%. Since the investor's tax rate on long-term capital gains is 15%, he or she would be taxed .15 x 100 x (71-50) = $315. The value of these WMT shares that could be invested in KO would essentially decrease from $7,100 to $6,785. All of a sudden, the income stream for the two options is much closer than it would originally appear, even though KO has the higher current yield.

Here is the formula I use to determine the necessary yield so that a stock switch increases income, accounting for taxes (note that this is not applicable to tax-free accounts).

Current Yield / (1-((Current Price- Purchase Price) x Tax Rate) / Current Price)

I have called this metric YAT (Yield Adjusted for Tax), and believe it is a very relevant factor for any dividend investor's toolbox. It shows the yield required from a new stock to fully replace the lost income from a sale of old stock, and is helpful when considering capital appreciation. Let's take a look at an example of an investor who bought 100 shares of Apple Inc. (NASDAQ:AAPL) during the financial crisis in 2008, when the stock was trading at $90 per share. Despite the recent decline in price, the investor has made a significant gain, with a current share price of $441 and yield of 2.40%. The investor is tempted to increase his yield by switching to Exxon Mobil (NYSE:XOM), with a yield of 2.55%. At first glance, he believes that he will increase his current income from $1080 to $1122 by converting his 100 AAPL shares to 492 shares of XOM. The investor realizes that he will have to pay a 20% tax on capital appreciation since the shares are not in any of his tax-free or tax-deferred accounts. This will cut into his capital, and decrease the number of shares he will be able to purchase. So, would it be worth it to sell AAPL for XOM? Plugging into the YAT formula, we can see the required yield to increase the dividend payments by switching out AAPL.

2.40% / (1-(($441-$90) x 20%) / $441) = 2.854%

As it turns out, switching from Apple to Exxon will not only decrease the value of the portfolio, but also reduce the income from dividends. The taxes on the sale of AAPL would be $7,020, reducing the amount of XOM purchased to 415 shares. Similarly, the annual dividend income would decrease from $1080 to $946. In this case, unless the investor felt that the dividend of AAPL was threatened or that XOM would grow its dividend at a much faster rate, it would not be advantageous to make the switch.

If the investor selects a company with a higher yield than the YAT threshold, the results will be very different. The investor chooses to sell his shares of Apple to buy stock in Microsoft Corporation (NASDAQ:MSFT), which pays a 3.3% yield. After paying capital gains taxes, the investor can scoop up 1324 shares of MSFT. These shares will then produce $1218 in annual income, a significant increase over the annual $1080 from AAPL. This is an example of how switching to a stock yielding above the YAT can be beneficial for income.

Similar to YOC, the YAT metric also takes into account the purchase price, and increases above current yield as the stock appreciates in value. YAT identifies the threshold at which switching out one stock for another can increase dividend income, accounting for taxes. It won't increase as much as YOC will, and may not make the investor feel as good about their investment, but I find that it is much more actionable information.

Disclosure: I am long AAPL, KO, WMT, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: A Less Taxing Way To Maximize Dividend Income