Let's talk about Yield on Cost (YOC).
In my view, Yield on Cost is not a good way to think about your current portfolio. It can lead you to make mistakes: you may hold on to stocks you happen to have owned for a long time ("it's got a great YOC!"), even if they are not good performers right now. That can be a very costly mistake.
But YOC is a very appealing way to think about what you want to accomplish in the future. Given an investment portfolio that is currently worth say $100,000, and say 20 years until to retirement, one useful way to think about how close you are to meeting your financial goals is to use dividend growth investing with a focus on a realistic YOC that can be attained 20 years out.
I was originally inspired to think about this topic by David Van Knapp, who stated a simple goal for his Dividend Growth Portfolio: he said he is looking to achieve 10% Yield on Cost in 10 years. Now that is a goal I can understand! If I have $100,000 invested today, and if I carefully invest it based on these principles for 10 years, then my goal is to end up with an income stream of $10,000 per year.
Or you can work backward. Say you want a $40,000 per year income stream in 10 years, and you want to work for 10 more years and not save another dime: if you think a 10% YOC in 10 years is reasoanble, then you need to have $400,000 invested today.
So David provided some nice groundwork, and a terrific, simple goal.
The next question is: how much growth does it take to hit that goal?
In other words, if I want a 10% YOC in 10 years, and my current portfolio yields 3% (or 4%, or 2%, or whatever), what annual growth rate in dividends will be needed?
I also wondered what it might take to hit a YOC of 25 percent in 20 years. (Because those are also round numbers, and I find round numbers easy to work with.)
So I wrote up an excel spreadsheet to find the answers.
For simplicity, I made the following assumptions:
(1) Dividends grow at a steady rate each year;
(2) Dividends are reinvested at the end of each year;
(3) The yield stays the same each year. (So if a given stock starts out earning 5%, we'll assume it will continue to earn 5%.)
Results are below:
|Initial Yield||Annual Dividend Growth Required to get to 10% YOC in 10 Years||Annual Dividend Growth Required to get to 25% YOC in 20 Years|
So say the current dividend yield for your portfolio is 3.5%. You need to see annual growth in actual dividends paid of 7.31% per year for the next 10 years if you want to hit a 10% YOC in 10 years. If your goal is 25% YOC in 20 years, starting from the same point, you need to see growth of 6.60% per year over that time period.
This can also be applied to individual stocks. Let's say you are thinking about buying AT&T (NYSE:T) and Walgreens (WAG). Let's say that T is currently yielding 5.0% and WAG is yielding 2.5%. If you're looking at the 10-year picture, and income is your only goal, then WAG needs to grow its dividends by a full 12.08% per year just to match what T can do by growing its dividends at just 2.07% per year! If you are looking 20 years out, it looks a little better for WAG, which only has to grow 9.46% while T has to grow 3.22%. But that's still a pretty big gap.
I don't know about you, but those numbers surprised me. Current yield matters more than I thought it did. If you start from a low yield, you have to perform pretty spectacularly to make up the ground compared to a higher initial yield.
Something else that surprised me: If you start with a yield of about 5.75 percent or higher, your dividends can actually trend down slightly over 10 years, and due to reinvestment of dividends (presuming all dividends can also be reinvested at the same rate) you can still get to a 10% YOC in 10 years.
Of course all of this is just math. It doesn't predict any specific returns you can expect from any actual investment. It's pretty unrealistic because yields do vary from year to year. And of course nothing here constitutes investment advice in any form whatsoever. But I found it interesting and hope that some of you may, too.
Maybe it'll even be useful.
Let me know! Thanks.
Disclosure: I am long WAG, T.