How Yield on Cost Works

| About: McDonald's Corporation (MCD)

An important concept in income investing is yield on cost, but it is often misunderstood. Let’s look under the hood.

The basic idea is easy: Yield on cost is the income yield, right now, on money that you invested 10 minutes ago, a few months ago, or 10 years ago. It is determined by this simple formula:

Yield on Cost = Past 12 Months Income / Price You Paid

I use the past 12 months’ income in this formula, because it is the only income we are sure about. (“Indicated” yield, based on the expected continuation of the most recent dividend payout, is also often used. I explain the nuances at the end of the article.)

Here’s an example taken from the latest Portfolio Review of my illustrative Dividend Portfolio. The review was conducted in August (read about it in this article: “Portfolio Forensics”), so the “Price Now” number is out of date, but it is perfect for illustration.

Stock

Date Bought

Price When Bought

Price Now

Price Return %

Current Yield

%

Yield on Cost

%

Action

to Take

MCD

4/30/08

3/30/09

60.06

53.93

71.70

+19

+32

3.1

3.7

4.1

Hold

Click to enlarge

You can see that I purchased McDonald's twice, in April 2008 and again in March 2009. The “Current Yield” column shows MCD’s yield at the time of the review, based upon its price then. Note that it is the same for both purchases. That’s because current yield is based on current price.

Current Yield = Past 12 Months Income / Current Price

There’s only one current price.

In contrast, the “Yield on Cost” column has two yields, one for each purchase. That’s because yield on cost is based on the price you paid, not what the stock is selling for today. Note how my first purchase (2008) is now yielding 3.7%, while my second purchase (2009) is yielding even more, 4.1%. That is because the price went down between my two purchases. Each of the two purchases of MCD pays out the same dividend per share. But when you convert that dollar number into yield on cost, the divisor is different for each purchase, hence there are two yields on cost. The only way they would be identical is if the price had been identical when I made each of the two purchases.

This simple example allows me to illustrate several bedrock principles of dividend growth investing.

Each time the dividend increases, your yield on cost goes up. I went back and checked the then-current yield of MCD on the dates I made the two purchases. In 2008, it was $1.875 / $60.06 = 3.1%. In 2009, it was 1.75 / 53.93 = 3.2%. (Don’t be misled into thinking MCD lowered its dividend from 2008 to 2009. At the beginning of 2008, MCD switched from a single annual dividend to four quarterly dividends per year. The 2008 calculation “caught” an extra quarter of dividends, namely the first quarterly payment in March 2008.) Because of MCD’s annual dividend increases, my yield on cost on the two purchases has risen from 3.1% to 3.7% for the first purchase, and from 3.2% to 4.1% for the second purchase. The increase in yield on cost is a mathematical certainty if the dividend is increased, because the divisor (the price you paid) remains the same for as long as you own the stock.

Yield on cost is a measure of current performance, not past performance. This issue came up in a recent comment thread on Seeking Alpha. A commenter stated that yield on cost is a backwards-looking measure. That is incorrect. Because it is based on the most recent 12 months’ dividend payout—the last annual amount that we know for sure—yield on cost is a current measure of performance. Of course, today’s yield on cost “got there” because of past dividend increases, but it is a current performance metric.

Yield on cost is directly comparable to a bond’s yield. Bonds, as we all know, are fixed-income investments. You pay $x for the bond, and its yield is stated and set for the term of the bond. It is a contractual obligation of the bond issuer, to whom you have lent money by buying the bond. So if you bought a bond yielding 4% in 2008, it is still yielding 4% to you. It will always yield 4% to you. It may pay a different current yield to someone who buys it on the bond market today (because its price may have changed), but that has no impact on its yield to you. Its yield on cost will always equal its yield on the day you bought it.

Yield on cost can be considered to be your “personal” yield on a dividend-paying stock. It is dependent on the price you paid. The current yield stated in the newspaper or on Yahoo or Morningstar applies to someone who purchases the stock today. It is irrelevant to your yield on cost.

The dividend increases in a dividend-growth stock can cause its yield to surpass that of a bond which may have started out ahead. As just stated, if you buy a bond yielding 4% and hold it, it will always yield 4% to you. But the increasing dividends of a dividend-growth stock will cause its yield on cost—your personal yield—to inexorably climb, often reaching and then surpassing the annual income on a bond that originally paid more. In the year following my 2008 purchase of MCD, it paid $1.75 per share in dividends, or 2.9% based on my purchase price. In the past 12 months, it has paid me $2.20, or 3.7%. That’s a 26% increase in dollars in just a year. Looking ahead, MCD has already announced an increase in its dividend for the fourth quarter of this year, from $0.55 to $0.61, an 11% hike that will raise the dollars to me in the next 12 months to $2.44, for a yield on cost of 4.1% on my 2008 purchase. (This is the forward-looking “indicated” yield on cost; see the last paragraph of this article.)

Price and initial yield matter. My 2008 purchase at $60.06 had sunk to $53.93 by the time of my second purchase in 2009. Why would I buy more of a sinking stock? Because it was a better deal (a classic value-investing concept). I had long-term faith in McDonald’s the company. I wasn’t thrilled that its price drop had cost me 10% in capital losses. But I didn’t plan to sell it, and in dividend growth investing one focuses on the dividend stream. In the year between the two purchases, MCD had jacked up its dividend from $1.50 in calendar 2007 to $1.625 in 2008 (an 8% jump), and it would jack it up another 26% in 2009 to $2.05. I could not have expected that magnitude of increase, of course, but I certainly expected an increase—after all, MCD had been raising its dividend for 32 consecutive years.

Yield on cost and current yield gradually diverge from each other. If a stock’s price increases at exactly the same rate that the company increases the dividend each year, the current yield won’t budge. This fakes out some people, who equate yield on cost to current yield. As we have seen, they are quite different, as the yield on cost rises with each dividend increase. Some dividend-growth investors believe the increasing dividends are themselves a major reason that dividend-growth stocks tend to wallop all stocks in total return. The reasoning is that if the price decreases, the current yield increases, making the stock more attractive to income investors, who pile into the stock and drive its price back up—so the stock’s price tends to rise along with its dividend. It is not unusual to see a stock’s current yield stay pretty much the same year after year, even though its dividend is raised each year. The dividend increases are matched by approximately equal percentage increases in the price of the stock, so mathematically the current yield stays the same. MCD’s current yield is 2.9%, and its indicated current yield is 3.2%, both in the same range as when I bought it in 2008 and 2009. But my yields on cost, as already explained, are much higher.

If you don’t separate out new purchases from old ones, your “blended” yield on cost will often go down with a new purchase. Many readers follow Dividends4Life’s periodic updates on his income holdings. Each time, he reports that new purchases have slightly downgraded the overall yield on cost of his whole portfolio. That’s because a new purchase at, say, 3.1% current yield, when combined with an old purchase at, say, 4.1% yield on cost, will make the combined yield on cost lower. (At the moment of purchase, yield on cost and current yield are identical.) That’s why I track each purchase separately. It makes clear what is really happening: The new purchase has not diminished the yield on cost of a purchase made years ago. That never happens. What does happen is that the yield on cost of the original purchase continues to march upwards, while the new purchase starts at its current yield on the day of purchase, then commences its own upward march when the next dividend increase is declared.

Finally, a couple of points about the basic formulas. (1) The formula for yield on cost could be Yield on Cost = (Last Quarter’s Dividends x 4) / Price You Paid. That formula differs from the one stated at the beginning of this article only in that it projects the current dividend payout rate forward (without presuming an increase). The proper name for this is “indicated” yield on cost. (2) A similar change can be made in the formula for current yield, producing the “indicated” current yield.

Disclosure: Author is long MCD.