There have been many articles written lately on so-called "double" or "complex" compounding for dividend growth stocks where an investor gets not only a compounding effect from reinvesting dividends (similar to the compounding effect for fixed income), but also gets a second compounding effect from annual dividend increases.
One of the concepts that has frequently come up in this context is "yield on cost" as a method to measure how successful this double compounding has been over time. However, there are some different schools of thought as to what "cost" is. Some define "cost" as simply their original investment in a stock with no subsequent additions or subtractions to this amount. These are the investors that often say they are generally unconcerned with the underlying price of a stock as it has no effect on yield on cost or their dividend income stream. I will call this "Yield on Original Cost".
Others have a more complex definition for "cost," adding in reinvested dividends to the original investment (resulting in what the IRS generally recognizes as "basis"). I will call this "Yield on Adjusted Cost". Finally, there is a third camp that considers "cost" as the current price of the stock (so-called "mark-to-market"). For this camp, yield on cost is really what is generally recognized as "Current Yield."
So how do these different metrics for yield on cost relate to each other? Is one "better" or "different" than the other as a way to assess relative performance? Is there anything interesting that analyzing these metrics might reveal?
To see, I went back to the same model I used in my article here. The hypothetical stock for this article is a blue chip with strong and steady fundamentals, a 4% "going-in" dividend yield and steady dividend per share growth of 5% per annum (I am hoping this will sit better with those "real worlders" who disliked my prior use of 3% and 3%). A ten year period is again used and all dividends are reinvested as I have chosen to analyze this is if it were held in an IRA. The only variable that I altered in this analysis is price appreciation.
The first spreadsheet (Spreadsheet 1) assumes that there is no price appreciation. You will note that the "Yield on Original Cost" increases nicely each year starting at 4% as one would expect moving up to 9.54% at the end of the tenth year.
The "Yield on Adjusted Cost" also starts out at 4% and increases as well , but at a slower rate than the "Yield on Original Cost" (as you would expect since "cost" is also increasing each year) reaching 6.21% in the tenth year.
The "Current Yield" tracks in tandem with the "Yield on Adjusted Cost" as, with 0% appreciation, they are effectively one in the same. Please note, for future discussion, the total amount of dividends received is $6,333.68 for this scenario. Click to enlarge:
The second spreadsheet (Spreadsheet 2) assumes that there is 5% price appreciation per annum. Again, "Yield on Original Cost" improves nicely starting at 4% but ends up at 8.69%, less than the 9.54% in the 0% price appreciation model...interesting.
The "Yield on Adjusted Cost" again starts at 4% and increases to 5.71% again short of the increase realized in the 0% price appreciation model.
The "Current Yield" stays steady at 4% through the entire period which you would expect as the price appreciation is keeping pace perfectly with the rate of dividend growth. All three metrics showed decreases in their values but, again please note for future discussion, the total amount of dividends received, in this case is $6,077.17. Click to enlarge:
The third spreadsheet (Spreadsheet 3) assumes that there is 10% price appreciation per annum. Again, "Yield on Original Cost" improves but ends up only at 8.12%; A trend is noted. The "Yield on Adjusted Cost" again starts at 4% and increases only to 5.39%. The "Current Yield" starts at 4% but actually declines through the ten year period falling to 2.63%.
Again, please note the total amount of dividends received in this case is $5,895.18. Click to enlarge:
So what were the take-aways from this? Well, no doubt I expected the "Current Yield" to be affected by differences in price appreciation. If the dividend grows at a steady rate but the price changes at different rates--less or more-- I expected the "Current Yield" would move in the opposite direction to the rate of price changes, which it does.
What I did not expect, initially, was a similar effect for "Yield on Original Cost" and, more importantly, for the total amount of dividends received. After all, the original cost didn't change, the dividend per share increases were the same...so what changed?
The difference was the total number of shares owned in the tenth year. In the 0% appreciation scenario, there were 1,633.37 shares owned at the end of the tenth year while in the 10% appreciation scenario there were 1,340.68 shares owned...292.69 fewer shares! Why is this? It is because under the higher price appreciation scenario the reinvested dividends were buying fewer shares each year.
So, for those who believe that a stock price other than the purchase price does not affect return on cost or dividends earned, here's your proof that it does, because the stock price at which you reinvest your dividends is almost never the same price as your original investment.
This will, in turn affect the number of shares you own and therefore your "Yield on Original Cost" and, more importantly, the absolute amount of the dividends you receive. Ironically, this effect is inverse to the rate of price appreciation of a stock; the greater the rate of price appreciation, the lower the total dividends and vice-versa.
As to which metric is better in assessing the comparative performance, if I used a yield on cost metric (which I do not), I would probably use "Yield on Adjusted Cost" as at least it takes into account the varying prices at which you have reinvested your dividends which, as you can see, is important. Admittedly, it is a bit more complicated to do it this way but, no doubt, it will give you a better sense of how dividend reinvestments have comparatively affected returns among your various holdings.
"Current Yield" is a good spot check, but it only tells you where you stand that second...nothing about past performance. So, happy calculating!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
