Many dividend investing conversations revolve around the
term “yield”. Simply defined, dividend yield
is the dividend payment divided by the price of the stock. For instance, a company paying a dividend of
$1 with a stock price of $20 delivers a 5% yield: 1 / 20 = .05 or 5%.
The concept is straight forward and provides a benchmark useful
in comparing the quality of alternative investments or assessing the
performance of a single investment across multiple points in time e.g., 1 year
ago, 3 years ago, 5 years ago, and today.
The difference between yield on cost and yield on price falls primarily into
the second category offering a trending viewpoint for an investment. To an extent, it also provides an
opportunity-cost perspective on switching investment positions.
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| Comparing Yield on Cost Across Alternatives |
Assume for a moment that you bought ABC Corps. 10 years ago
because it had a 5% yield. You did so
believing it was a quality company with a solid dividend. Furthermore, you were aware that ABC’s yield
was superior to rates on other investment vehicles like bonds and treasuries
paying roughly 2%-3% or CDs and money markets paying less than 1%.
10 years later, you review your ABC Corps investment and
discover it is still paying a 5% dividend while bonds, treasuries, and CDs have
been creeping up the yield curve. Do you
abandon your ABC holding in favor of an alternative showing yield growth during
that period?
Assume that over the last decade ABC has increased in price
from $20 a share to $40 a share representing a compound annual growth rate of
approximately 7%. This is close to the
market’s historical average. During the
decade, ABC held its yield constant at 5%.
At $40 a share the 5% yield now equals $2.00 which means dividend
payment or cash flow is double what it was when you bought it. ABC has obviously been increasing the amount
of its dividend payment on a regular basis and in healthy increments.
A secondary assumption is that you made no additional
purchases of stock, other than DRIP
investments through your broker. The
shares you initially purchased at $20 each are now paying $2.00 in dividends
delivering a yield of 10%: (2.00 / 20 =
10%) relative to your initial cost.
Consequently, your yield on cost is significantly greater than your
yield on price based upon today’s stock value, which is fantastic. More importantly, it’s unlikely that vacating
ABC in favor of a new bond or treasury investment will result in a cash flow
stream anywhere near 10%.
How does this work?
It’s straight forward. The cost
of the stock your purchased 10 years ago did not change but the amount of the
dividend being paid relative to it increased nicely.
Why is this important?
The price of an investment you purchase today doesn’t change over
time. This is true of real estate,
stocks, bonds, gold, baseball cards, etc.
In all cases, the cost point remains constant. On the cash flow side of the equation, only
dividend stocks and rental real estate offer potential for increased cash flow
across your time horizon. See the posts
on real
estate for additional thoughts on that investment vehicle. The rest of the investment world offers no
opportunity for increasing cash flow without requiring additional transactions
e.g., sales, purchases, calls, loans, etc.
The short story is that dividend stocks with strong payment
histories, finite downside, and minimum overhead are one of the best methods of
compounding
your investments over time to reach your objectives. Being aware of how yield on original cost differs
from yield in current price further highlights the gulf between dividend paying
stocks and alternatives. This awareness
is helpful when assessing the opportunity cost of vacating dividend paying
stocks for alternatives and further demonstrates why solid dividend paying
stocks should be strong considerations within any portfolio.
The thoughts
and opinions expressed here are those of the author, who is not a financial
professional, and should not be considered as investment advice. The
information is presented for consideration and entertainment
only. For specific investment advice or assistance, please contact a
registered investment advisor, licensed broker, or other financial professional
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