Is Yield On Cost Really Important To Dividend Investors?

Includes: MCD, PG
by: David Crosetti

In his first article, "Don't Let The Yield On Cost Lull You Into Complacency," Larry Layton begins by saying:

Yield on cost is a great concept and certainly gives the investor a good feeling as it climbs from the yield at time of purchase to a higher and higher yield as the years pass. However, placing too much attention on Yield on Cost will cause you to miss opportunities in the market. There is a point when harvesting gains must be considered. By harvesting gains and reinvesting into other opportunistic stocks, your yield on cost as measured by your original investment increases dramatically.

Here is a link to Larry's article.

There has been a lot of discussion about Yield on Cost here at Seeking Alpha, but many people seem to be confused as to its value and its proper use in looking at our portfolios. I have given a lot of thought to the concept of Yield on Cost and I would like to share some of my findings with you. We are going to look at two Dividend Champions. The first is Procter and Gamble (NYSE:PG) and the second is McDonald's (NYSE:MCD) two companies that are held by many dividend investors. But before we begin, let's start at the beginning.

Yield on Cost: A Definition

What exactly is Yield on Cost (YOC)? Google YOC and you will get thousands of hits that will give you a mathematical definition and some will even expound on the value of using this particular metric. At Investopedia, they define YOC this way:

The annual dividend rate of a security divided by the average cost basis of the investments. It shows the dividend yield of the original investment. If the number of shares owned by the investor does not change, the yield on cost will increase if the company increases the dividend it pays to shareholders; otherwise it will remain the same.

As pointed out by others, YOC is a phenomena that takes place at the time of purchase. Every adjustment we make to the cost basis of a particular position will change the actual YOC number. So, if today I make an initial purchase of say, NUE at $35.90 and Nucor pays a dividend of $1.45 a share, my YOC will be 4.038%.

A Look At Procter and Gamble (PG):

So, for example, if you were to have purchased shares of Procter and Gamble (PG) at the closing price on Friday, November 18, you would have paid $63.24 a share, and would receive a current dividend per share of $2.10, so your YOC would be 3.3%.

Now, as the definition of YOC mentions, if you never purchase another share of PG and take your dividend payments and use them for some other purpose other than reinvesting in PG stock, then as PG raises its dividend in the future, your YOC will increase.

Now over the last 3 and 5 year periods, PG has increased its dividend by 11% annually. This year, though, it increased the dividend by 9.5%. For argument sake, let's say that PG increases its dividend 10% a year over the next 13 years. Based on the cost of PG mentioned above, what happens to your YOC over the next 13 years?

As a PG investor, based on the criteria explained above, your YOC would grow to 10.42% in 13 years, Your dividend income would be $659.07 a year and that income would continue to grow, as long as the dividend continued to grow as well. But, in the real world, we need to not only forecast ahead, but also "back test" and see what would have happened to an investor in PG who purchased the stock in January 0f 1999. Click to enlarge:

Click to enlarge

The original price that the investor would have purchased PG for was $45 a share in January 1999. The dividend at that time was .63 a share, which meant there was a YOC of 1.39%. The prices moving forward are as of the first trading day of January for each year. The value of the 100 shares of PG changes over time. The dividend amount changes as well. The YOC grows to 4.67%, but the actual yield the investor is receiving is 3.24%. The YOC number is larger, in this instance, because the dividend has grown over time and the YOC is based on the original purchase price of $4500.

A Look at McDonald's (MCD):

Again, following the same assumptions as with Procter and Gamble. We have purchased McDonald's (MCD) for a price of $92.74, which was the closing price on Friday, November 18th. The current dividend is $2.80 per share and that is a yield of 3.02%. Assuming that the dividend grows 10% a year, and you do not add to your position, your yield will rise to 11.47% in 13 years.

Again, the dividends will increase moving forward, your income will increase, and all things being equal your YOC should grow significantly over the next 13 years.

Looking at MCD from a historical perspective, though, the picture resembles the one we've seen from PG. An investor who purchased MCD at the closing price, on the first day of trading in January 1999 would have purchased MCD for $38.47 a share. The dividend at that time was .20 a share, which was a dividend yield of .51%.

Over the next 13 years, the yield rose to the current 3.02%. Again the interesting point here is to look at the actual history of what has happened and then compare that to the charts moving forward. In both cases, reality vs. projection seem to be incompatible with one another. Click to enlarge:

Click to enlarge

The initial purchase of MCD in January of 1999 would have been made at $38.47 a share. The dividend was .20 a share or a yield of .52%. As the price of MCD changed each year, so did the dividend. The YOC grew to 7.28% for the investment made in 1999, but the actual yield is 3.02%.

Conclusions and Summary:

Many investors regard the metric we know as Yield on Cost with an almost religious fervor. The level at which some investors will rail on either pro or con regarding YOC is quite interesting. For every investor who criticizes the metric, there is another who will defend it without fail.

Here's my issue with YOC. Both investors have had a nice increase in their YOC numbers. The YOC for the PG shares is 4.67% and the for the MCD shares it's 7.28%.

But that "return" is based on the initial cost and not the current value of the shares held. The true yield for both holdings is the same as the currently stated yield--that is 3.3% for PG and 3.0% for MCD. That would be the same return that would be generated with a new 100 share purchase of either of these two companies, today.

The YOC growth is telling the investor that the dividend has been rising over the years and not much else. It goes without saying that perhaps the investor would be better off looking at another investment that would, in fact, increase his actual dollar income coming in.

What we have with both of these stocks is this: MCD currently pays $2.80 per share owned; PG currently pays $2.10 per share owned. That's it. Again, since dividends are paid on shares owned, not the value of the position owned, focusing on the yield in and of itself may prevent an investor from making better decisions for his income stream.

This is where the argument gets started. I could suggest an alternative company and the comments would suggest that the alternate company may not be as good an investment in the future as PG or MCD will be. Or the argument may be that it will take 10 years to fully appreciate the impact of the decision to sell PG or MCD.

If we are truly investing for income, then maximizing the income flow and minimizing the risk taken would seem to be the wiser course of action. A position of 100 shares of "xyz" that currently yields 3.5% or 4.0% may be a wiser course of action for a dividend investor to investigate. When the % becomes more important than the actual dollars being returned through dividends, then I think we may want to rethink our position.

Disclosure: I am long PG, MCD, NUE.