The Yield-On-Cost Trap, And When To Sell

Includes: JNJ, MCD, V
by: The Investing Engineer

I have several stocks in my portfolio with a rather large yield on cost. While some people might find this impressive, I'm going to demonstrate that it means very little when figuring out the real value of your shares.

For those unfamiliar with the term, yield on cost (YOC) is the current annual dividend payout, divided by your per-share cost basis. For example, say I bought 100 shares of McDonald's (NYSE:MCD) in 2003 for $23 per share, and then another 100 shares of MCD in 2005 for $30 per share. My cost basis is $5,300. I got this from adding the $2,300 I spent in 2003 with the $3,000 I spent in 2005. My per-share cost basis is then found by dividing the $5,300 by the number of shares I own, or 200, giving me a per-share cost basis of $26.50 (this is just my average price per share). In 2011, when MCD paid out a total of $2.53 in dividends, my yield on cost was $2.53 divided by $26.50, or 9.5%.

My initial reaction to that is to be impressed and maybe give myself a pat on the back. By holding on to my stock for a number of years, I'm now making a very large dividend on what I consider to be a stable company. Because MCD is currently dominating its market, it will mostly likely continue to grow its dividend, giving me an even greater YOC over the years.

While this is all very good, it ignores something crucial; the YOC only looks at the cost basis and doesn't take into account the extra purchasing power you have if the share price increases.

What I mean is this: I paid $5,300 for 200 shares of MCD, but those shares in 2011 would be worth $18,000, based on a price of $91 per share. If I sold my MCD shares and bought a stock with a dividend yield below 9.5%, I could still end up making a higher overall dividend because I would have had $18,000 to spend, instead of the original $5,300.

With a $2.53 annual dividend per share in 2011, I would have made $506 from MCD. If instead I took the $18,000 and bought 295 shares of Johnson & Johnson (NYSE:JNJ) for $61 per share, I would have made an annual dividend return of $663.75. Keep in mind that based on those numbers, JNJ had a YOC of only 3.6%, significantly below the 9.5% of McDonald's.

So, the big question now is: How do I figuring out when the increased purchasing power from my stock will allow me to increase my dividend? Fortunately, this is very simple: the current yield. In 2011, MCD had a dividend yield of about 3.2%. At the same time, JNJ had a dividend yield of about 3.6%. No matter what I originally paid for my shares, the current yield takes into account the actual market value, while YOC doesn't. This means that no matter what the YOC, if you sell your shares and by new shares of a company with a higher dividend yield, you will end up ahead.

If you've made it to the end of this article and you think that this was very obvious and a waste of time, think about this; there are some people that have been holding onto stocks such as Visa (NYSE:V), which pays a very low dividend yield of 0.66% and will not sell it because they have a very high YOC. If any of these people follow a strict dividend growth investing strategy, holding onto Visa is a mistake, because the purchasing power you have from the increase in share price over the past few years is making you no money. That person should sell Visa and buy a stock with a higher dividend yield to put all of that profit to good use. (For someone not following a dividend growth strategy or who cares more about the potential future worth of the stock instead of the dividend, however, Visa might be a great stock to own.)

Disclosure: I am long MCD, JNJ. 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.

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