Why Yield On Cost Is A Sucker's Statistic

| About: Realty Income (O)

Summary

It seems many investors use YOC as a leading measure for sell/hold decision making.

Yield on Cost is just an illusion and a product of one's mind twisting perspective.

This article seeks to illuminate those who are letting YOC anchor their investment decisions.

After a fairly long hiatus from Seeking Alpha, I decided to write an article discussing why I decided to sell my Realty Income (NYSE:O) shares from my IRA. In addition, multiple contributors joined the debate, such as Dane Bowler's short thesis, and Brad Thomas's long thesis article shortly after.

Setting my opinion aside, and upon reading into the debate, one of the most intriguing considerations displayed by long investors in the debate was the consideration of their "yield on cost" (YOC). In addition, it came up in the comments section rather often, and I felt it was widely misunderstood, and thus being misused.

What exactly is YOC? Quite simply, YOC is an investment's dividend divided by the original cost of the investment. Seems simple until both the share price and dividend are increased. For example, suppose you bought Realty Income shares back in the year 2000 when it paid out $1.11 in dividends for $10/share. Click to enlarge

Today, shares are trading @ $63/share, and the dividend has been increased to roughly $2.38. This would equate to a yield on cost of over 20%. It is because of this seemingly high yield metric that causes long time shareholders to get gun shy, despite acknowledgement of overvaluation. This is a huge mistake since shares really only yield ~4%, and you could make more dividend income finding another stock that yields more than the 4%, not the 20% statistic.

Suppose you bought $4,000 worth of stock and it's doubled to $8,000, and the yield on cost has increased from 6% to 12% as well. This would mean in the current year you're collecting $480 since 6% * $8,000 = dividend $. If you sold all your shares and swapped that $8,000 into a different stock yielding more, say 8%, you will increase your dividend income to $640. Because you are investing the total $8,000 and not the original $4,000 cost the YOC focuses on, you will earn more switching into a stock that is yielding less than the YOC, because it's more than the real time yield. In this example, even paying 15% tax on your gains while switching still wouldn't counteract the benefit of this switch as far as the dividend payments are concerned.

Judging from many comments, it seems investors feel as though they would need to find an alternate investment currently yielding this same as their YOC to generate the same income they have in their existing investment. However, in reality, this is simply not true, as they'd only need to find an investment yielding the same real time sub 4% yield to get an equal dividend payout in their account.

For example, I encountered a gentleman named Victor in the comments following my article on Realty Income:

I admit, as a dividend investor, YOC does make me feel warm and fuzzy inside, especially a 20% YOC in the example above. However, YOC really should have little bearing on your investment decisions, since it's nothing more than an alternate way of measuring your share price gains, or a way of seeing how a stock has risen versus the dividend payout. The funny thing is YOC depends a lot on your perception; there are many logical ways of thinking about it. However, when comparing dividend yields between companies or simply trying to decide whether to sell O to buy another, use their real time yield, not your YOC. This is the only accurate perception to use; reality.

After reading both of these excellent articles and the many others out there, I still feel shares of O are overvalued relative to alternative REITS by most metrics like P/FFO, FFO growth, dividend growth, dividend yield, etc. (these metrics are well explained by Dane's article, see link above). However, as Brad articulated in his piece, I don't see a significant catalyst to warrant Danes' short thesis, especially since 95% of O's debt is fixed rate, so increasing interest rates will have less direct effect. Therefore, I would consider myself somewhere between being a short like Dane and an uber long like Brad, but still I feel O is a sell here.

In summary, YOC is a fun statistic to use, and if it's higher than your original yield chances are you made a good investment. However, I don't think it's a worthy consideration when comparing and analyzing like stocks, or deciding whether to sell or hold. If you are, you are being a sucker.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in O over the next 72 hours.

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.