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Although I think it's safe to come out now, there has previously been an onslaught within Seeking Alpha as to the appropriateness of the Yield on Cost (YOC) metric. For those of you that happily side-stepped the line of fire, essentially the premise is that YOC measures dividend income on a historic cost; of which the opportunity cost is not aptly accounted for and the stock's current yield, rather than YOC, details your true income level. I'm here to say that yes, this argument is mechanically correct, but that doesn't mean that YOC is useless. In fact, I'd like to advocate that the average dividend growth investor should go about their prospective investments as if they were on a quest for a 100% yield on cost. I'll get to the why soon enough, but sometimes people inquire as to where my enthralling article ideas spring from. This one is relatively simple, coming from Berkshire Hathaway's 2010 Shareholder letter:

"Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn't be surprised to see our share of Coke's annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business."

And it follows that Warren Buffett likely knows what he's talking about. Berkshire Hathaway (NYSE:BRK.A) will almost certainly receive $408 million (400 million shares X $0.255 quarterly payout X 4 quarters) in dividend payments during 2012. Given Coca-Cola's (NYSE:KO) streak of increasing dividends for 50 straight years and its wide economic moat, it can be expected that BRK.A will continue to see a larger and larger paycheck from KO each year.

So let's consider the math of Buffett's statement for a moment. In order for the dividend to double in 10 years' time, Coca-Cola would have to increase its dividend by about 7.2% on average each year. (Rule of 72, 72/10 = 7.2%, or else the actual calculation, 2^ (1/10)-1=7.177%) Now obviously, past dividend increases tell you little about future endeavors; but we know that Coca-Cola at least has a propensity to continually reward shareholders:

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Here we see, via Chuck Carnevale's F.A.S.T. Graphs, that averaging 7.2% dividend growth (at least historically) hasn't been an issue for Coca-Cola; so far, so good. Additionally, you can verify that the 1995 dividend of $0.22 a share multiplied by Berkshire's 400 million shares equals the Buffett quoted $88 million number.

What about the total earnings exceeding initial cost claim? At a current share count of 400 million and 2011 Earnings per Share of $1.92 we find Berkshire Hathaway's earnings claim on Coca-Cola to be $768 million. Considering that BRK has a cost basis of $1.299 Billion, this means that Coca-Cola needs to grow its earnings by about 6% annually over the next 9 years. This too appears reasonable:

(click to enlarge)

In fact, keeping in mind that historical numbers aren't particularly enlightening, we see that Coca-Cola was able to growth EPS by 9% a year over the last 13 years and doubled the earnings amount in the last 8 years.

Add in the fact that Coca-Cola recently announced a 500 million share buyback program to continue its 28-year streak of ongoing share repurchases and you can probably see that Buffett's 2010 assumptions aren't altogether outlandish as much as they are reasonable. In true Buffett fashion, he was suggesting: "I don't look for 7-foot bars to jump over; I look for 1-foot bars I can step over." That is, 7% dividend growth and 6% earnings per share growth appear to be a reasonably low bar for Coca-Cola moving forward.

So my first thought was having a yearly ownership claim that exceeds one's initial investment is pretty cool. But my second thought was: "How do we make this a bit cooler?" And the answer was instantaneous: not just a yearly earnings ownership claim above one's initial basis, but also a yearly dividend payout that covers one's cost basis. That is, having a yield on cost of 100%.

So within our BRK & KO parameters, how long would such an instance take? Whipping out your financial calculator and using the $408 million current payout to Berkshire, a $1.229 cost basis and a dividend growth rate of 7%; we find a time value of 16.3 years. Perhaps I'm easily excited, but to me this seems like an extraordinary feat. Every year moving forward Berkshire would receive more in dividend payments from Coca-Cola then it initially invested. Imagine buying a house for $100,000 and 30 years later the rental income is $110,000. While it should be noted that the applicable opportunity costs must be weighed such that the $110k and original $100k are nowhere near comparable in today's dollars; don't forget that you would have been rewarded with a rising stream of income throughout the years as well.

Using this novelty, you could do fun calculations like finding that a 3% current yield with a 8% dividend growth rate takes 46 years to reach a 100% YOC, a 2.5% yield with a 12% growth rate takes 33 years to reach 100% YOC, a 3.5% yield growing at 10% takes 36 years and a 6% current yield increasing by a constant 5% each year would take 58 years to reach full YOC. I suppose such calculations might provide a lesson on the value of not just current yield, but also a high growth rate; that is, finding the 'dividend growth sweet spot.' But again you would have to consider what you could have done with the initial funds instead. And while we have the capability to make such an analysis, that's not the point that I'm trying to make.

The point is that if you approach income investing, especially dividend growth investing, with the ideology of achieving 100% yield on cost in the future, then it brings about a variety of wonderful things. (Even if you don't eventually reach this goal.)

First and foremost, a rising yield on cost means that your income is increasing, the precise goal for a dividend growth investor. Obviously we want to make sure that it is rising by a rate that fairly compensates our future purchasing power, but increasing nonetheless. Secondly, an increasing YOC necessitates, rather than precludes, long-term capital appreciation. Coca-Cola, Johnson & Johnson (NYSE:JNJ), Kimberly-Clark (NYSE:KMB), Procter & Gamble (NYSE:PG), PepsiCo (NYSE:PEP), McDonald's (NYSE:MCD), and all the other dividend risers are never going to have a 100% current dividend yield. For that matter, they will likely never have a 50%, 25% or even 10% current yield either. Thus if you build a rising stream of income, especially once your yield on cost starts into the double digits, capital appreciation will come right along with it.

Next, although this is elsewhere observable, a focus on achieving a mammoth YOC gives you a good indication as to when you might consider selling a partnership. If the dividend isn't increasing, your YOC is stagnant and you won't reach your end goal. Even if the dividend is increasing by a slow rate, it would be discernible that your end goal is becoming harder to obtain.

Perhaps my favorite application of the YOC metric is that it forces you to have a long-term view. In considering our extreme case of 100% YOC, it would be impossible to buy Coca-Cola or Johnson & Johnson today and reach that 100% YOC goal in the next year, five years or likely even a decade or two. Even if your goal is a more attainable 50% YOC or simply double digit YOC, this process is going to take a while. Thus, you focus on making the best possible business decision in the beginning such that you can reap the benefits of a growing dividend for many decades to come. Of course there are exceptions. For example, if you bought Apple (OTC:APPL) near its lows in 2003, you would be currently enjoying a 92% YOC just 9 years later, despite its lack of payout in the prior 8 years. But we know that such cases are rare and in general the longer we partner with the best businesses in the world the better off we will likely be.

Finally, if you're not yet convinced that YOC can be useful (perhaps you never will be), I'll give it one more shot. Imagine that market prices are collapsing. In fact, you probably don't have to imagine; simply go back to your 2009 statements. If you don't yet have the fortitude to stick with the best partnerships in the world simply because they are the best business partnerships, perchance you could lean on the YOC metric. I acknowledge that this is simply another way to look at total income, but it does add a touch of comparative simplicity. When we see these falling prices there is potentially a very good reason in the short-term: analysts, institutions and other money heavyweights have both the knowledge and fear to make defensive decisions. In fact, some of your favorite companies might even be making less money in the short-term. But if they're anything like Coca-Cola, Procter & Gamble, Johnson & Johnson and the other dividend growth stalwarts, they still have the ability to increase their dividends. That is, as prices plummet, your total income and thus yield on cost would be increasing. If your goal is an increasing YOC over time, then the appropriate action is to buy more, not to panic and sell, thereby destroying the YOC that you have created. The only way for your YOC to increase is for the underlying partnership to hand you more money.

Useless or not, here's to your quest for 100% yield on cost.

Source: The Quest For 100% Yield On Cost