If I bought a private operating company such as a car wash, a storage unit, or a local pizza parlor, I would take a look at two things: how much profit I could take out of the company (i.e. a dividend), and how much I had to reinvest back into the company for growth, maintenance, and debt repayments (i.e. retained earnings). Additionally, I would measure my success by being able to both (1) increase the amount of profits that the small business generated, and (2) increase the amount of profits that I could take out of the company.
This is why I think it is important to use dividend yield-on-cost and earnings yield-on-cost as a tool in evaluating the long-term performance of my holdings. When I make an investment in a company today, I want to know what kind of profits my capital will be generating five years from now, ten years from now, and so on. This thought process as a long-term business owner is completely independent of worrying about what price other enterprising investors would be willing to pay to take the business off of my hands.
This is the important distinction between a short-term trader and a long-term investor. A short-term trader spends his time trying to exploit a discrepancy between the current stock price and a future estimation of what other investors are willing to pay for the stock. A long-term investor, on the other hand, spends his time focusing on the earnings growth (and perhaps dividend growth) over his contemplated holding period to carry the day. However, this does mean that a long-term investor is ignorant about prevailing and future market prices. As Professor Benjamin Graham explains in The Intelligent Investor :
The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.
Aided by Graham's logic, I can condense long-term investing into a three-step process:
(1) Find an attractive business selling at a reasonable (or even cheap!) price.
(2) Derive investing returns primarily from the underlying earnings growth and (as applicable) dividend growth of the business.
(3) Sell when one of the following conditions occur: (a) the fundamentals deteriorate, (b) the company makes a shift in business strategy that is difficult to understand, perhaps such as Bank of America (NYSE:BAC) acquiring Countrywide, (c) the company becomes so expensive that the valuation becomes disjointed from reality, (d) a much more lucrative investment appears judged by your own opportunity costs, or (e) "life happens" and you need the money to meet your lifestyle funding needs.
What is interesting, though, is that most investing discussions focus on becoming an investor in a stock or selling an interest in a stock. Very little discussion focuses on what should be the most important part of investing: being a holder of the stock.
This is where I find it useful to keep track of the earnings yield on cost and dividend yield on cost. When I become the owner of a company, I want to track the business performance of the assets over time. The prices only matter when you buy or sell. If you're going to hold an asset for 10+ years, the performance of the asset (not the price fluctuations of the asset) should be the guiding focus.
I'll give a few examples:
Procter & Gamble (NYSE:PG) has grown earnings by 9.0% and dividends by 11.0% over the past ten years. If you paid $4,000 to buy 100 shares at $40 in 2002, your initial dividend was $76 annually while generating $180 in earnings. Now, that same pool of capital generated $214 in dividends and $385 in earnings at year-end 2012. Those are the results you achieved in terms of business performance.
Johnson & Johnson (NYSE:JNJ) tells a similar story. If you held the stock for the past ten years, and paid $5,000 to buy 100 shares, you received $80 in initial dividends while the company earned $223 in your first year. By the end of 2012, you received $240 in annual dividends while the company generated $510 in normalized earnings. Your initial dividend yield was 1.60%. Your initial earnings yield was 4.46%. Now, you would be receiving a 4.80% yield on cost while generating an earnings yield-on-cost of 10.20%.
The results from Johnson & Johnson reinforce an important lesson about blue-chip investing (and all investing in general): a great company can become a less-than-great investment once you reach a certain price. Johnson & Johnson the business did perfectly well from 2002-2012: the dividend tripled and earnings increased 2.28x. Operationally, these results of the business were sound. If you are dissatisfied with the income and earnings results that you personally achieved over a ten-year holding period, it is because you paid too much (what do you expect to happen when you initiate a large-cap investment with a 1.60% dividend yield while paying over 22x earnings?).
Chevron (NYSE:CVX) provides a good example of what can happen when you pay a rational price for a cash-generating business over a ten year period. In 2003, Chevon was paying out $1.43 in dividends while generating $3.48 in earnings. If you paid $35 per share, you could have bought 200 shares for $7,000. Your starting dividend yield was a little over 4% and your starting earnings yield was a little under 10%. For patiently waiting 10 years, those 200 shares are now generating $720 in annual dividends, and using the analyst consensus for 2013 earnings estimates, $2,980 in annual earnings. That's a dividend yield on cost of 10.29% for waiting ten years, while the business itself is generating an earnings yield on cost of 42.57%. This is the kind of situation you can set yourself up to benefit from if you identify an excellent company within an industry that is experiencing nice tailwinds (long-term rise in the price of oil) and pay a rational price for it.
When we own a private business or operating company, we measure our success by the growth of the business itself. If we own the local apartment complex, we would measure our results by saying, "In 2003, I generated $50,000 in rents and was able to take $30,000 out of the business for myself while reinvesting the other $20,000 for future expansions and growth." When 2013 rolled around, you would probably think, "I generated $130,000 in rents and was able to take $70,000 out of the business while reinvesting the other $60,000 for home improvements and expansion that will allow me to receive more rents in the future." You would not spend your time obsessing over what it was worth unless you intended to sell.
But yet, when it comes to individual common stock holdings, we often get suckered into measuring our success by the change in price that other people are willing to pay for the security, rather than the price of the business itself. If someone says, "General Electric (NYSE:GE) delivered returns of 11.73% since 1970", that only refers to the dividends paid out plus the positive price change of what other investors were willing to pay for the business. That information is particularly useful when you're considering the sale of a stock. But I choose to focus on being the holder of an excellent business once the initial purchase is made. In order to that, I like to focus on the relationship between my capital outlays and the growth of the business over time while also considering what effects the change in dividends have on my household income.
Disclosure: I am long BAC, PG, JNJ, GE. 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.