Dividend Growth: A New Way Of Looking At Yield On Cost

Includes: CSCO, O, PG, TGT
by: Adam Aloisi

For an increasing number of investors, generation of a growing, sustainable income stream has become a notable priority. Ideally, implementation of such a strategy could produce substantial income increases during one's retirement. One of the tracking methods that dividend growth investors commonly utilize is known as yield on cost, or simply YOC. Yield on cost gauges the yield that a investment generates over time and is measured by the following formula:

For example, let's say that an investor bought shares of Procter and Gamble (NYSE:PG) for $54 a piece on August 8, 2005. In 2005, PG's quarterly dividend was .28, providing for a $1.12 annualized dividend rate and roughly 2.07% yield on those purchased shares. Today, PG pays out about $2.40, more than double what it did in 2005. To calculate the yield on cost of the original investment, we take $2.40 and divide it by the $54 original cost basis and calculate that our original shares now have a YOC of 4.44 percent. The calculation becomes a bit more difficult as more purchases are made or dividend reinvestment occurs, with each transaction affecting the average overall cost of shares.

For reference, let's calculate the compound annual growth rate of P&G's dividend over the past eight years. Compound annual growth (OTCPK:CAGR) can be calculated as follows:

If we plug the numbers in with $2.406 (exact PG dividend rate) for ending value, $1.12 for beginning value and 8 as the number of years, we come out just over a hair over 10%. This means that on average, over the past eight years, Procter & Gamble has raised its dividend 10% a year.

Looking Forward With Yield On Cost

While most investors tend to utilize YOC as a backward looking progress metric, I "yield" that dividend growth investors additionally should be utilizing it as a forward, extrapolative, metric to determine if a particular security is suitable or not for future income goals.

For instance, if one's goal is to generate 10% YOC on a security and the current yield is 5%, what kind of dividend growth and time assumptions must one make in order to facilitate that 10% end? Let's take a popular dividend growth stock, Realty Income (NYSE:O), and facilitate a forward YOC simulation utilizing three separate dividend growth scenarios.

The scenarios will take on what I consider pessimistic, realistic, and optimistic forward dividend growth of 5%, 8%, and 12%. Our goal is to obtain 10% YOC, or double the initial income on the shares. We will utilize Realty Income's current vitals to run the simulation, meaning purchase of shares at $43 a piece (on 8/8/13) with an annualized dividend of $2.178, or a current yield of 5.06 percent.

Future compound growth can be calculated by the following formula, where "PV" represents current yield, "r" represents the dividend growth rate, and "n" represents the number of years the compounding will occur. FV would represent our future YOC. You can utilize free, readily available sites on the Internet such as this one to plug in your own scenarios and/or assumptions and calculate future YOC rather easily.

Realty Income's Assumed Dividend Growth Rate YOC After 4 Years YOC After 8 Years YOC After 12 Years
5% 6.15% 7.48% 9.09%
8% 6.88% 9.37% 12.74%
12% 7.96% 12.53% 19.71%

My personal feeling is that the 8% dividend growth rate, or perhaps a bit less, given current fundamentals, is perhaps most realistic for O going forward. If that's the case then our goal of doubling the current 5.06% yield will take more than 8 years to accomplish. If we lower expectations to 5% then it will take more than 12 years to accomplish. Our optimistic scenario would see an income double in around six years.

Decisions, Decisions, Decisions

Depending on income goals, time constraints, and initial yield purchase, one can make the determination whether a security picked specifically for income growth makes sense or not. If you think Realty Income's dividend growth going forward is nearer our pessimistic 5% assumption and need greater dividend growth, then maybe you should opt for a stock with a lower current yield, but higher assumed dividend growth rate.

Stocks like Target (NYSE:TGT) and Cisco (NASDAQ:CSCO) have publicly stated that it is their goal to return cash to shareholders going forward. The problem here however is that the pure income investor is starting with half the dividends compared to O, as TGT and CSCO currently yield only 2.4% and 2.6%, respectively. However, with our forward looking formula, assuming Target is able to grow its dividend 15% over the next 9+ years, an investor will achieve 10% YOC. If Cisco grows its dividend 13% over the next 11 years, again, 10% YOC.

If one wants to shorten the time period or increase the starting yield, there are other options to consider, but dividend growth rate and reliability as well as overall portfolio risk may be compromised. Business development companies -or BDCs-, mREITs, MLPs, and some closed-end funds offer elevated yields and potentially income growth, but be prepared, depending on the equity chosen, for inconsistency, and potentially an erratic, bumpy ride for both income growth and capital conservation.

Increasing Your Forward YOC Odds

If income growth is your goal, given the rather arbitrary nature of corporate dividend policy, there is no steadfast way to assure that your income stream will continue to rise. Bumps in the corporate road, even for stalwart blue chips, can lead to dividend disruptions, freezes, declines, and in worst case scenarios, discontinuation. Thankfully, they are usually the exception rather than the rule. Although as the recent situation at Intel (NASDAQ:INTC) can attest, dividend investors can sometimes be thrown a curve ball, forced to reassess their commitment to dividend growth stocks that may now be perceived as undependable.

While the following attributes aren't necessarily indicative of a company poised to aggressively increase its dividend, they may be viewed as a substantial defense against dividend disruption.

  • Low payout ratios relative to earnings and free cash flow
  • High cash positions relative to market capitalization
  • A history of consistent timing and amount of dividend increases
  • Consistent earnings and free cash flow growth to support distribution increases
  • Management's stated commitment for dividend growth

Some of my favorite personal portfolio holdings, held at least in part for the likelihood of future aggressive dividend growth would include the aforementioned Target and Cisco, Apple (NASDAQ:AAPL), Accenture (NYSE:ACN), as well as smaller caps like American Realty (ARCP), Textainer (NYSE:TGH), and NorthStar Realty Finance (NYSE:NRF).

Final Thoughts

Yield on cost is typically perceived as a backward looking metric to evaluate one's ongoing cash flow progress and the compound annual growth rate of a dividend. However, I think one can just as easily utilize it as a forward looking mechanism to assess if an equity is capable of achieving future income needs and goals. Though its use might be considered far from scientific, I think it forces investors to develop a tangible investment thesis based on forward corporate fundamentals, assumed dividend growth rates and sustainability, payout ratios, and balance sheet analysis.

Disclosure: I am long AAPL, ACN, ARCP, CSCO, INTC, NRF, TGH, TGT. 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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.