How Reinvesting Dividends Accelerates Yield on Cost

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Includes: BXS, CINF, CTL, LLY, SPY
by: David Van Knapp

Last week, my article “How Yield on Cost Works” discussed the basic yet oft-misunderstood concept of yield on cost (YOC). In a nutshell, it explains why your personal yield from a dividend stock goes up as the company increases its dividends. The reason is because your personal yield is based—and always will be based—on the price you paid for the stock. That’s what the “C” in YOC stands for: Your cost. It is not affected by changes in the price of the stock after you bought it. If you make additional purchases, each new purchase has its own YOC.

The formula is:

Yield on Cost = Last 12 Months’ Dividends / Price You Paid

A simple example would be this: You pay \$50/share for a stock that, in the past year, paid \$3/share in dividends. Your YOC is \$3 / \$50 = 6%. (The dollar signs cancel out, leaving you with a pure ratio or percent.) Say the company increases its dividend 6% in the coming year. Your YOC increases right along: \$3.00 + 6% = \$3.18. YOC = \$3.18 / \$50 = 6.36%. Your YOC went up at the same rate as the dividend did.

One commenter, David Fish, said not to forget the additional payback that comes from reinvesting the dividends. Good idea. Many (or even most) dividend-growth investors reinvest their dividends. To see what impact this has, let’s chart the course of the example above through 10 years. We need to make a few simplifying assumptions:

• The stock’s price grows each year at the same rate as its dividends. This is a reasonable simplification. Many companies increase their dividends each year at the approximate rate that their earnings increase. In a simpler world, the market would recognize the earnings increases with proportionate increases in the stock’s price. (That is, the P/E ratio would stay the same.)
• We start out by purchasing one share.
• The growth in stock price and dividends each year is 6%.
• The increases take place at the end of the year, just after we reinvest the dividend. Partial shares can be purchased. These timing simplifications eliminate confusion about timing and let us isolate the basic concept for examination.
• Brokerage fees and taxes are ignored.

OK, let’s see what happens. We need a name for this accelerated YOC. Because one often sees total stock returns described as “dividend-reinvested returns,” let’s use the same terminology here: “Dividend-Reinvested Yield on Cost,” or DRYOC. Numbers in the table below are rounded to a sensible number of significant digits.

DRYOC EXAMPLE

 Year Price \$ Dividend / Share \$ Current Yield % YOC % Shares Owned Dividend Collected \$ DRYOC % Shares Bought 1 50.00 3.00 6.00 6.00 1 3.00 6.00 0.0600 2 53.00 3.18 6.00 6.36 1.0600 3.37 6.74 0.0636 3 56.18 3.37 6.00 6.74 1.1236 3.79 7.57 0.0675 4 59.55 3.57 6.00 7.14 1.1911 4.25 8.50 0.0714 5 63.12 3.78 6.00 7.56 1.2625 4.77 9.54 0.0756 6 66.90 4.01 6.00 8.02 1.3381 5.37 10.7 0.0803 7 70.91 4.25 6.00 8.51 1.4184 6.03 12.1 0.0850 8 75.16 4.51 6.00 9.02 1.5034 6.78 13.6 0.0902 9 79.67 4.78 6.00 9.56 1.5936 7.62 15.2 0.0956 10 84.45 5.07 6.00 10.1 1.6892 8.56 17.1 0.1014 TOT 39.52 53.54 0.7906

Notice anything interesting?

• DRYOC starts accelerating away from YOC immediately after the first year. By Year 5, DRYOC is 26% higher. By Year 10, it is 69% higher: Your DRYOC is 17.1% compared to YOC of 10.1%. After 10 years, you have collected 35% more dividends than if you had not re-invested them.
• YOC by itself is nothing to sneeze at. By Year 10, you are receiving 10.1% on your original investment, when your yield started at 6%. Note that Year 10 yield (10.1%) is approximately equal to the historical total annual return of the stock market.
• YOC contains some compounding itself. That’s because the company’s annual 6% dividend increase is itself a compounding number: Each year’s new dividend is computed by adding 6% to last year’s dividend. Without this compounding, the Year 10 dividend would have been \$4.80 rather than \$5.07. (That is, it would have been 6% x 10 years, or 60% higher than Year 1.)
• The same compounding as just described is also taking effect with regard to the stock’s price. In Year 10, the price is 69% higher than in Year 1. Without that compounding, the price in Year 10 would have been \$80.00 (or 60% higher) instead of \$84.45 (69% higher).
• DRYOC adds a second layer of compounding to your dividend yield as a result of your using each year’s dividends to buy more shares. It is the additional shares that increase the dividend received each year beyond YOC times 1 share, the original share you purchased.
• Reinvesting dividends also adds a second layer of compounding to the total value of the stock you own, because at the end of 10 years you own 1.7906 shares instead of one share. Multiplied by the Year 10 price, that means that you own \$151.22 worth of the stock. This is more than three times what you paid for that original share.
• Current yield stays the same, 6%. That is a mathematically guaranteed outcome from the fact that the company raised its dividend each year by the same percentage that its price increased. I believe that this is part of the reason that some investors get confused and equate YOC and DRYOC with current yield. Their thinking is not precise when it comes to these concepts, and they will refer to a stock’s current yield as if it represents the actual yield of a dividend-growth stock purchased several years earlier. The actual yield, YOC, departed from current yield as soon as the company raised its dividend, and as we have seen, if the dividends are reinvested, DRYOC moves ahead at an even faster clip. Understanding the difference between current yield and either YOC or DRYOC requires the ability to appreciate the effects over time of annually increasing dividends and compounding.

Are there stocks that actually do this? Yes. Perusing David Fish’s Dividend Champions document, I found that 61 of the 101 companies with 25-year+ dividend increase streaks had 10-year dividend growth rates of 6% or more. Many of them were much more, including 37 with double-digit 10-year growth rates. Most of the 61 stocks do not have current yields of 6% or nearly that, but six of them do: Altria (MO, 6.8%), Bancorp South (BXS, 6.9%), CenturyLink (CTL, 8.0%), Cincinnati Financial (CINF, 6.0%), Eli Lilly (LLY, 5.8%), and Leggett & Platt (LEG, 5.6%). I suspect that there are others if you go back to stocks with 10-year, 15-year, or 20-year increase streaks.

I did not go back and research whether their prices had maintained the same pace. However, this is about dividend-growth investing, so it is proper to stay focused on the increasing dividends and yield aspects of the stocks.

As always, the stocks listed are not recommendations. Do your own due diligence before investing in anything. Also, on a related subject, some of you may want to refer back to my article, “10 by 10: A New Way to Look at Dividend Yield and Growth,” for perspective on how initial yield and dividend growth rates interact with each other over time. You can get similar results with different combinations of the two. For example, you can get to 10% YOC in about 10 years with a stock that started at 3% yield and increased it 13% per year; or with a stock that started at 4% and increased it 10% per year; and so on.

Disclosure: Author is long CTL