What Is Yield on Cost (YOC)?
Yield on Cost (YOC) is an important metric for dividend growth investors, designed to help them understand the actual return they are generating from their investments based on the price they originally paid. It is calculated by dividing a stock's current dividend by the initial purchase price of that stock. For instance, if an investor bought a stock five years ago for $20, and the stock now pays a dividend of $1.50 per share, the YOC would be:
[ YOC = \frac{Current\,Dividend}{Original\,Purchase\,Price} = \frac{1.50}{20} = 0.075 \text{ or } 7.5\% ]
It's crucial to differentiate YOC from the current dividend yield, which is calculated using the stock's current price. Understanding these two concepts helps investors evaluate and compare their investment strategies better.
Key Takeaways
- Historical Perspective: YOC is strictly based on the original price paid for the investment, making it a retrospective measure.
- Growth Potential: YOC can increase significantly over time if the company consistently raises its dividends, exemplifying the long-term benefits of investing for dividend growth.
- Comparative Analysis: Investors must be cautious not to equate YOC with other stocks' current dividend yields, as they serve different purposes in investment analysis.
The Mechanics of Yield on Cost
YOC highlights the long-term returns from an investment. Companies that regularly increase their dividends allow their shareholders to achieve substantial YOC over time. In fact, it's not uncommon for seasoned investors to own shares where the YOC is equal to or exceeds 100%—the dividends received surpassing the initial investment amount.
For accurate calculations, it’s essential for investors to document all related costs associated with their holdings, including any additional shares purchased and transaction costs. This comprehensive approach ensures that YOC reflects the true yield and does not mislead investors into thinking they have gained more than they have.
YOC vs. Current Dividend Yield
Comparing YOC to the current dividend yield of another stock can create confusion. A higher YOC does not inherently make an investment favorable. For instance, if a company has a YOC of 35% but its current dividend yield is lower than another company’s current yield of 8.50%, the decision to hold that stock needs re-evaluation. This comparison emphasizes the importance of growth potential versus immediate returns.
For an informed decision, an investor must consider:
- Future Growth Prospects: The potential for dividend increases is critical.
- Risk Tolerance: Stocks with higher yields may carry a higher risk of dividend cuts in times of economic downturn.
Long-Term Advantages of Yield on Cost
Investors focusing on YOC highlight not only the power of compounded returns but also the resilience of dividend-paying stocks compared to fixed income securities. Unlike bonds, which typically offer fixed interest rates, dividend-paying stocks can increase their payouts over time, positioning them well in the long-term investment landscape.
Example: Yield on Cost in Action
To illustrate, let's look at a hypothetical scenario involving Emma, a retiree evaluating her investments. Emma's portfolio includes a significant holding in XYZ Corporation, acquired 15 years ago at $10 per share. Initially, XYZ had a dividend yield of 5%, with dividends at $0.50 per share.
Over the years, XYZ consistently increased its dividend by $0.20 annually, culminating in a current dividend of $3.50. Despite the stock price climbing to $50, Emma's YOC stands at an impressive 35%:
[ YOC = \frac{3.50}{10} = 0.35 \text{ or } 35\% ]
While pleased with her returns, Emma faces a challenge when her portfolio manager sells XYZ in favor of ABC Industries, which boasts a current yield of 8.50%. Emma initially reacts negatively due to her high YOC but learns from her manager the importance of comparing current yields directly.
Conclusion
Yield on Cost is a powerful tool for investors who prioritize income generation, especially those focusing on dividend growth. While it serves as an impressive measure of past investment performance, it must be used in conjunction with other financial metrics for a well-rounded investment strategy. Understanding both YOC and current dividend yield is crucial for making informed decisions that align with one's long-term financial objectives. Through comprehensive analysis and strategic planning, investors can maximize the benefits of their dividend-paying investments.