When Should I Use Yield On Cost, And When Should I Use Current Yield?

by: Robert Allan Schwartz

Summary

There are times when yield on cost is the right tool for the job.

There are times when current yield is the right tool for the job.

How can I tell which is which?

A workman on a construction site has many tools at his disposal [e.g. hammer, saw, drill, etc]. He must learn when to use which tool, because if he uses the wrong tool, he won't solve his problem, and he might cause damage.

An income investor has many tools at his disposal [e.g. yield on cost, current yield, etc]. He must learn when to use which tool, because if he uses the wrong tool, he won't solve his problem, and he might cause damage.

Is a tool good or bad?

That's the wrong question.

Consider a scalpel. If a surgeon uses it to remove your burst appendix and save your life, then that is a good use of the tool. If a robber uses it to coerce you to hand over your money, then that is a bad use of the tool.

It is the use of the tool that is good or bad.

The tool itself is neither.

Let's define some terms and specify some units and metrics.

The term "current dividend" means "the number of dollars that one share of a company will pay me during some interval". For convenience, let's specify the interval as one year. It is a metric measured in units of dollars per share.

Example: Company A pays a current dividend of $5/share.

The term "current income" means "[number of shares * current dividend]". It is a metric measured in units of dollars.

Example: I own 100 shares of Company A, each of which pays a current dividend of $5/share. Over the next year, I will receive $500 [100 shares * $5/share] in current income.

The term "purchase price" means "the number of dollars that you paid when you purchased one share of a company". It is a metric measured in units of dollars per share.

Example: I paid $100/share for Company A.

The term "yield on cost" [YOC] means "current dividend / purchase price". It is a metric measured as a percentage.

Example: I paid $100/share for Company A. Company A pays a current dividend of $5/share. My YOC is 5% [$5/share / $100/share].

The term "current price" means "the price the market charges to buy or sell one share of a company at this instant". It is a metric measured in units of dollars per share.

Example: The current price of Company A is $80/share.

The term "current yield" [CY] means "current dividend / current price". It is a metric measured as a percentage.

Example: The current price of Company A is $80/share, the current dividend is $5/share, so the CY is 6.25% [$5/share / $80/share].

How do I measure the current income from an existing income investment?

As mentioned above, one way to measure current income is "[number of shares * current dividend]". I own 100 shares of Company A. The current dividend is $5/share. The current income is $500 [100 shares * $5/share].

You can use CY to measure current income: "[number of shares * [current price * CY]]". The current income is $500 [100 shares * [$80/share * 6.25%]].

You can use YOC to measure current income: "[number of shares * [purchase price * YOC]]". The current income is $500 [100 shares * [$100/share * 5%]]".

The three formulas are equivalent.

How do I measure the income performance from an existing income investment?

You use YOC.

All other things being equal, if Company A has a higher YOC than Company B, then Company A is "better" than Company B, because Company A produces a higher current income than Company B.

Example:

I paid $100/share for Company A, which pays a current dividend of $5/share.

My YOC on Company A is 5%.

If I paid $100 for 1 share of Company A, then my current income is $5.

I paid $50/share for Company B, which pays a current dividend of $3/share.

My YOC on Company B is 6%.

If I paid $100 for 2 shares of Company B, then my current income is $6.

[Please note that I am not suggesting that an investor use only this one metric. This is one of many metrics that an investor might use to evaluate their investments. Please perform all due diligence before you invest.]

YOC is the right tool to use to measure the income performance of an existing income investment.

Can I use CY to measure the income performance of an existing investment?

No.

Suppose I paid $100/share for Company A, which pays a current dividend of $5/share.

My YOC on Company A is 5%.

Suppose the current price drops to $80/share.

The CY rises to 6.25%.

Am I receiving 6.25% on my existing investment?

No.

I paid $100/share.

I receive a current dividend of $5/share.

I receive $5/share on my investment of $100/share.

I receive 5% on my existing investment.

My YOC on Company A is still 5%.

[YOC does not depend on current price, so YOC doesn't change when the current price changes.]

Who receives 6.25% on their investment?

Only those investors who purchase Company A at the current price of $80/share.

CY is the wrong tool to use to measure the income performance of an existing income investment.

How do I measure the current income from a potential income investment?

You use CY.

Suppose you're considering purchasing $9,000 worth of Company C. Its current price is $90/share. Its current dividend is $4.50/share. Its CY is 5% [$4.50/share / $90/share]. The number of shares is 100. Its current income is $450 [100 shares * $4.50/share].

What if, between the instant when you decide to purchase, and the instant when the trade clears, the current price went up? What if the trade took place at $100/share, with a current dividend of $4.50/share, with a CY of 4.5% [$4.50/share / $100/share], with a number of shares of 90, with a current income of $405 [90 shares * $4.50/share]? Your current income would be 10% less.

What if, between the instant when you decide to purchase, and the instant when the trade clears, the current price went down? What if the trade took place at $81/share, with a current dividend of $4.50/share, with a CY of 5.5% [$4.50/share / $81/share], with a number of shares of 111.11, with a current income of $500 [111.11 shares * $4.50/share]? Your current income would be 10% more.

It is impossible to exactly predict CY [and therefore the number of shares and the current income] before the trade clears, but CY is a reasonable approximation.

As mentioned above, you can use CY to measure the current income from a potential income investment: [number of shares * [current price * CY]].

Of course you could also use [number of shares * current dividend].

CY is the right tool to use to measure the current income from a potential income investment. [You haven't purchased it yet, so there is no purchase price, so there is no YOC.]

When you purchase shares, you "freeze" the CY [which depends on current price, which changes every instant, so it is like looking at a movie] into the YOC [which does not depend on current price, so it is like looking at a photograph].

How do I measure the income performance from a potential income investment?

You use CY.

All other things being equal, if Company D has a higher CY than Company E, then Company D is "better" than Company E, because Company D will produce a higher current income than Company E.

Example:

Company D has a current price of $100, a current dividend of $5, a CY of 5%, and 100 shares would result in a current income of $500.

Company E has a current price of $50, a current dividend of $3, a CY of 6%, and 200 shares would result in a current income of $600.

An investor would choose to spend $10,000 on 200 shares of Company E rather than on 100 shares of Company D.

[Please note that I am not suggesting that an investor use only this one metric. This is one of many metrics that an investor might use to evaluate their investments. Please perform all due diligence before you invest.]

CY is the right tool to use to measure the income performance of a potential income investment.

Will I receive more current income if I sell shares in Company A and buy shares in Company F?

Here's one way to decide:

Measure the current income of Company A:

[number of shares * current dividend], or

[number of shares * [current price * CY]], or

[number of shares * [purchase price * YOC]].

Measure the cash from the sale of Company A:

[number of shares * current price].

Measure the number of shares of Company F that this amount would purchase:

[cash from the sale of Company A / current price of Company F].

Measure the current income of Company F:

[number of shares * current dividend], or

[number of shares * [current price * CY]].

But there is a much simpler way, outlined in my article "How To Raise Portfolio Income By Selling Overvalued Companies":

"How do I know that the net result of selling the [Company A] and buying [Company F] will raise portfolio income? This question is easy -- if the current yield on [Company F] exceeds the current yield on [Company A], then portfolio income will rise."

"I find many things fascinating about this example: (1) The amount you originally paid for [Company A] is irrelevant; (2) Yield on cost (YOC) is irrelevant; (3) The number of shares of [Company A] and [Company F] is very different; (4) The price/share of [Company A] and [Company F] is very different; (5) The dividend/share of [Company A] and [Company F] is very different. The only thing that is relevant is that the current yield of [Company F] is higher than the current yield of [Company A], so portfolio income rises."

YOC is the wrong tool to use to decide if selling and buying will raise portfolio income.

CY is the right tool to use to decide if selling and buying will raise portfolio income.

Conclusion

Income investors need to know when it is appropriate to use YOC:

  • You can use YOC to measure current income: "[number of shares * [purchase price * YOC]]".
  • YOC is the right tool to use to measure the income performance of an existing income investment.

and when it is appropriate to use CY:

  • You can use CY to measure current income: "[number of shares * [current price * CY]]".
  • CY is the right tool to use to measure the current income from a potential income investment.
  • CY is the right tool to use to measure the income performance of a potential income investment.
  • CY is the right tool to use to decide if selling and buying will raise portfolio income.

Ecclesiastes was [sort of] right: "There is a time for everything, and a season for every activity under the heavens: a time to use YOC and a time to use CY".

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.