Written by Sam Kovacs
Investing, just like poker, is very much a number’s game. Like when playing poker, sentiment, psychology and expectations also come into play. But these are always indexed to the numbers. And one sure way to lose money – both at poker and in the markets - is by using the wrong numbers.
Investors who refuse to sell stocks which have extremely low dividend potential because they have a massive yield on cost are just like poker players who raise all-in when they hold a pair of aces, even while facing 4 players with a flush draw.
They looked at the numbers correctly, they are simply looking at the wrong numbers.
Source: Open Domain
Now don’t get me wrong, yield on cost has some marginal utility, but it should never be used when deciding whether or not to keep or sell a stock.
The irrelevance of yield on cost
About seven years ago, there was this guy who worked out in the same gym as me. We were both 6 feet tall, I weighed about 185lbs, he weighed about 175lbs. I remember being secretly stocked that I could bench press 220lbs while he could only bench 185lbs.
I’ve moved to three different countries since, but recently came across a recent Facebook photo of his. The guy has become a physical freak. Ripped abs, huge upper body, your typical bodybuilder. I sent him a private message, saying “bet you can bench 220 now”.
He responded saying, “in fact I can bench 300, but you know, I weigh just over 230lbs.”
Note that he didn’t say: “I bench 300lbs, which is great considering I weighed 175lbs 7 years ago.” Because that would be irrelevant. Sure, it shows good progress, but that’s about it.
Yet dividend investors make this mistake every time. They own a position in a stock which yields 2% and say: I don’t care, I have a yield on cost of 20%, I bought this ages ago.
When your yield on cost is higher than the current yield, it means you’ve made a profit. And that profit has value.
Looking at yield on cost suggests that the unrealized capital gain has no value.
Investors will say things like “I’d like to sell my shares of XYZ, but my yield on cost is too high, I’d never find a replacement stock.”
And that’s the fallacy. Looking at yield on cost skews your assessment of opportunity cost.
Let’s look at a scenario.
10 years ago, you bought a stock – let’s call it stock A - for $100 per share, which yielded 3% - or $3 per share - at the time. Over the course of the last 10 years, the dividend doubled to $6 per share, but the price tripled to $300 per share.
Your yield on cost is 6%. But the current yield is now 2%.
For each share you own, you’re receiving $6 in dividends each year. You could also share your shares for $300.
Now let’s say there is another stock – stock B - which you like the look of. It also trades at $300 per share, but yields 4%, or $12 in annual dividends per share.
An investor who uses yield on cost to make decisions would conclude that 6% is higher than 4%, and that all else held equal, he would be better off keeping his shares of stock A.
Yet, if we assume no commissions, and no capital gains tax, the investor could instantly double his income by selling stock A for $300 and buying stock B for $300.
Yield on cost is irrelevant because it fails to take into account opportunity cost. And if you aren’t considering opportunity costs when investing, you’re extremely unlikely to be successful.
Unfortunately, the current yield isn’t perfect either for comparing two stocks. When you own a stock with an unrealized capital gain, unless the shares are held in a tax-sheltered account, you’re going to have to pay capital gains tax.
Introducing the Yield on Sale (YoS)
We need a metric which we can use to compare the shares you own in your portfolio to other investment opportunities. This metric was briefly discussed in our article on “How To Sell Dividend Stocks To Increase Your Income”.
We have dubbed it Yield on Sale (YoS) thanks to the suggestion of one of our commenters, Nate the Great. (Thanks Nate.)
The yield on sale represents the yield at which you would need to reinvest the proceeds of selling a dividend stock to maintain your current income.
In other words, investing in stocks which have higher current yields than the yield on sale of your positions would increase your dividend income.
The formula for the yield on sale is as follows:
Yield on Sale = annual dividends / ((price – avg cost) * (1 – tax %) + avg cost)
Let's break it down for simplicity.
Just like a current dividend yield, you’re dividing the dividends by a dollar amount. This dollar amount is equal to the average cost of your position plus the capital gain net of capital gains tax.
In a tax-sheltered account, the Yield on Sale is always equal to the current yield, as demonstrated below.
YoS = annual dividends / ((price – avg cost) * 1 + avg cost)
YoS= annual dividends / (price – avg cost + avg cost)
YoS = annual dividends / price
For you to calculate the YoS of your positions, you need to know the capital gains tax rate which you pay.
This varies depending on the country and state in which you are a fiscal resident.
Let’s assume that all in, you pay a 40% capital gain tax, and use the example which was shown above.
You own stock A which trades at $300. You bought the stock for $100. The stock provides annual dividends of $6.
Current Yield = 6 / 300 = 2%
Yield on Cost = 6 / 100 = 6%
Yield on Sale = 6 / ( (300 – 100) * (1 – 0.4) + 100) = 6 / (200 * 0.6 + 100) = 6 / 220 = 2.73%
If you were to sell stock A for $300, after tax you’d have $220 left. For you to get at $6 in annual dividends from those $220, you’d need to invest in stocks which yield 2.73%.
Remember stock B? It also traded at $300 but had a 4% current yield. Since 4% is greater than 2.73%, you’d increase your income by selling A and buying B.
By how much? Simply divide the current yield of B by the yield on sale of A.
Income Increase of switching stocks = current yield of B / yield on sale of A -1
In this case 4% / 2.73% -1 = 46% increase.
As you can see if you had used yield on cost to make an investment decision, you would have missed an opportunity to increase your income significantly.
The Yield on Sale of losing positions
As much as we’d like to only invest in stocks which dominate the market, everyone occasionally has a stock which plummets. We try to avoid them as much as possible, but sometimes you miss something, and your investment turns south. It makes the case for having a diversified portfolio to limit the impact of any individual stock on your portfolio.
But these positions, when held in a taxable account, come with a silver lining. Realizing a capital loss means you will be able to offset any capital gains from other positions.
For instance, let’s say you buy stock B for $300 when it yields 4%. It’s paying you $12 in annual dividends.
Out of nowhere, the dividend is cut in half. The stock plummets to $150.
The current yield is still 4% ($6 / $150).
Your yield on cost is now 2% ($6 / $300).
But your Yield on Sale (assuming 40% capital gains tax) this time is lower than 4%, not higher.
Selling the stock would lock in $150 in capital losses, 40% of which can be used to offset other transactions.
So Your Yield On Sale is : $6/ ( ($150 - $300) * (1-0.4) + $300) = $6 / $210 = 2.8%.
The nuance here is that you won’t instantly increase your income by buying any stock which yields 2.8%. However, were your capital loss to totally be offset by other capital gains, you’d stand to increase your income overall by investing in anything with a 2.8% yield or higher.
The opportunity cost of your dividend income isn’t the only thing you should consider when deciding whether or not to keep a stock, you’d also factor in dividend safety, as well as potential for dividend growth and capital appreciation. You might also be motivated to sell to rebalance your exposure to a certain stock or sector, like we explained in our article on “Dividend Investing Strategy For Individuals Like You And Me.”
If you analyze stocks using the wrong metrics, you’ll likely have subpar results. Yield on cost is a vanity measure which fails to take into account opportunity cost. It became popular by its simplicity (yield on sale is harder to calculate), but it has no real use other than being a vanity metric.
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.