Consider the following hypothetical situation: On January 2, 1971, 21-year-old Jack has saved up $2,000 in his IRA and invests it in The Boeing Company (NYSE:BA), founded in 1916. His father warns him about putting this much money into one stock, but Jack has a strong interest in planes, has done his research, and feels good about the decision. Dividends are set up to automatically reinvest in Boeing. Forty-five years later (January 2, 2016), at age 66, Jack is ready to retire and start living off of the dividends. He has no intention of selling any shares, but plans to bequeath these shares to his heirs. He looks at the dividends received in 2015 as an estimate of what he might receive in 2016 -- $52,787 in dividend income for 2015 (refer to Exhibit I for details on these calculations). On an original investment of only $2,000 -- and that's in addition to a portfolio that is now worth over $1.8 million. Note that traditional IRAs were not available until 1974, but we will ignore that fact for sake of this illustration.
Although this is an extreme example, it does illustrate the power of the concept of yield on original investment (YOI), sometimes referred to as yield on cost (YOC). The 2015 YOI in this example is 2,639 percent -- 2015 dividends of $52,787 divided by an original investment of $2,000.
The purpose of this article is to explore the concept of YOI using three Dow stocks, Boeing, Exxon Mobil (NYSE:XOM), and Johnson & Johnson (NYSE:JNJ), as examples. I will also provide two formulas for estimating future YOI, given certain inputs. Unlike Jack, who gambled on one stock, prudent investors should invest in a larger number of stocks with a long history of growing dividends, or use appropriate mutual funds or exchange-traded funds (ETFs) to achieve their target YOI at retirement. I used three Dow stocks to illustrate because they have a longer history of dividends (back to 1971 and before) than mutual funds or ETFs. The first ETF appeared in 1993 with high-dividend ETFs arriving later. High-dividend mutual funds have a longer history than ETFs, but also have significant capital gains distributions and fluctuating dividend payments which make future YOI less predictable. All of the calculations in this article assume that a tax qualified account is used for the life of the investment.
YOI Over the Last 5, 15, and 25 Years
Most of the increase in YOI in the above illustration happened in the last 10 years (2005 to 2015) due to the power of compounding. Specifically, YOI for Boeing was 577 percent after 35 years in 2005; it was 2,639 percent after 45 years in 2015. Let's look at some shorter timeframes that are more realistic for people saving for retirement, specifically the last five years (2011 to 2015), the last 15 years (2001 to 2015), and the last 25 years (1991 to 2015). And let's add two more Dow stocks, Exxon Mobil and Johnson & Johnson to the analysis to see how the YOI of different stocks vary over these three time periods. The inputs in the following table for Exxon and Johnson & Johnson are the same as for Boeing (start with $2,000, etc.), but the results would be the same regardless of the starting investment. The annualized return of the S&P 500 Index is also included to add insight to the analysis. All prices and dividends used to create tables and worksheets in this article come from Yahoo Finance. Prices have been adjusted for multiple stock splits for all three Dow stocks.
The results are much less impressive than a 45-year timeframe, but are desirable when compared to alternative income-producing investments in this low interest rate environment. After only five years of reinvesting dividends, the three stocks compete favorably with today's high-grade fixed income investments. None of these three companies have reduced quarterly dividends over the period from 1991 to 2015, so a person can expect fairly stable or growing income from these stocks in the future. It is not difficult to search the Web for a list of other stocks known for a long history of stable and growing dividends. Assuming a retiree spends all dividend income and does not use it to buy additional shares, growing income to combat inflation will come from dividend increases by the company. In addition, the retiree will likely benefit from unrealized capital gains in the stock. Increasing dividends and significant capital gains are an advantage of this strategy over fixed income investments.
Adding 10 more years (2001 to 2010) of reinvested dividends does not increase the 2015 YOI significantly because of the poor performance of the market during this time. The S&P 500 Index averaged 10.2 percent per year from 2011 to 2015, but only 3.0 percent over the last 15 years due to the tech bubble bursting in 2001-02 and the 2007-09 recession. Clearly the overall market does influence YOI. Looking at the last 25 years (1991 to 2015) increases YOI considerably due to the power of compounding and the addition of the "Roaring 90s." The S&P 500 Index averaged 7.6 percent per year over this period.
The Benefits of a Recession
The Recession of 2007-09 caused a significant drop in the prices of all major asset classes. The prices of the three stocks in this article dropped from pre-recession highs to mid-recession lows as follows: Boeing -73 percent, Exxon -41 percent, and J&J -36 percent. During this time, the dividends for all three stocks either stayed the same from quarter to quarter, or increased. Falling prices, combined with level or increasing dividends, means higher percentage yields which benefit a person like Jack in the illustration above. An interesting experiment is to remove the recession from the data for Boeing to see how it would affect 2015 YOI. For example, if a stock has annual prices of 10, 8, 7, 9 and 11 through a four-year recession and recovery ($10 at the start of Year 1; $8 at the end of Year 1, etc.), the recession is removed by changing the prices to $10, $10.25, $10.50, $10.75, and $11. Quarterly dollar dividends are kept the same. Percentage yields will fall when the recession is removed due to the higher prices. The effect on 2015 YOI of removing the 2007-09 Recession from Boeing's stock prices is in the table below. We look at four different time periods to emphasize that the positive effect of the recession increases significantly with time.
During the recession, Boeing's stable and growing dividends could be used to purchase more shares at low prices than if the recession never occurred. Although a 73 percent drop in a stock price would be very anxiety-producing for any owner of Boeing who could hold on, the company never cut dividends during the recession, leading to a higher 2015 YOI after the recovery. Also note that the 2007-09 Recession occurred toward the end of each time period when the positive effect on 2015 YOI is greatest because the number of shares owned is at its highest.
Estimating YOI (Exhibits II and III)
We turn from looking at YOI using historical data for three companies, to providing a formula for estimating future YOI and a formula for estimating the number of years needed to reach a target YOI. These formulas are useful for retirement planning and can be set up in Excel so that a person can test different inputs. Refer to Exhibit II for some sample output from the first formula (estimating future YOI) and an explanation of the formula itself. Both formulas assume that dividends are reinvested, and that the stock price grows at the same rate as the dividend. A Year 1 yield of 3 percent is used because there are a number of large-cap equity mutual funds and ETFs which currently offer a yield of about 3 percent. As expected due to compounding, the table shows that a higher dividend growth rate has a more positive effect after more years, and more years have a greater positive effect at a higher growth rate.
Rearranging the terms in the first formula leads to the second formula (years needed to reach a target YOI). Refer to Exhibit III for some sample output from the second formula and an explanation of the formula itself.
It is understandable for investors to be concerned when the value of their portfolio drops significantly. As markets become more volatile, the occurrence of corrections and recessions will increase. Focusing on YOI, rather than portfolio value, is easier on the nerves because dividends tend to grow steadily over time. Even after a person stops reinvesting dividends and starts spending them, the number of shares may not increase, but dividends per share will increase to help fight inflation. In addition, YOI after a few years compares favorably to yields on fixed income investments in this low interest rate environment. For example, starting with a dividend yield of 3 percent in Year 1 and an annual growth rate in the dollar dividend of 6 percent, the investor can achieve a YOI of 6 percent in nine years, and a YOI of 10 percent in 15 years by reinvesting dividends. Mutual funds and ETFs are available to accomplish these goals, but the annual income after achieving the target YOI will be more variable than investing in a diversified portfolio of blue chip stocks with solid dividend histories.
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.