The importance of yield on cost

Yield on cost is a controversial term, which is calculated by dividing the dividends received from an investment over the cost paid for the shares. There are many arguments whether yield on cost matters or not. I typically view yield on cost as a forward looking metric, which combines my yield and growth expectations into a single indicator that translates into tangible dividend income at a future point. As a dividend growth investor, I want to purchase companies that can afford to regularly grow dividends out of consistent earnings growth.

For example, let’s assume that I invest in a company like Yum! Brands (YUM) which yields 2% today, but could easily afford to grow distributions by 12% /year over the next decade. This would be fueled by strong emerging markets growth in places like China, where competitor McDonald’s (MCD) is a distant second. While a 2% current yield is low for many income investors’ standards, a consistent growth in earnings and distributions could lead to much higher dividend incomes and strong capital gains for investors who buy today. A $1,000 investment today would generate $20 in annual dividend income. If annual dividends grow by 12%/year over the next decade, the annual dividend income will grow to $62, for an 6.20% yield on cost. Chances are that the stock will still yield 2% - 3% ten years from now. As a result, your $1,000 investment would likely have generated significant capital gains in the process as well.

When I first got started in dividend investing, I focused my energies on high-yield closed-end funds. I was attracted to their high yields, and monthly distributions. Unfortunately, at least once every year, each of these funds cut distributions. The stock price would fall, but the dividend yield would correct to the previous level. I would fool myself into believing that reinvesting the distributions into more shares would maintain my income and net worth. Unfortunately, the falling distributions meant that the share prices were declining, which meant that my losses were compounding. My yield on cost was decreasing as well. While my current yield was 10% – 12% on investments such as the Managed High Yield Plus Fund (HYF), my yield on cost was much less than that. Only through reinvestment of distributions was I able to have lower losses.

At the end of 1999, HYF traded at $10.70/share and paid 12.50 cents in monthly distributions. By 2004, HYF was trading around $6/share, and paying a monthly distribution of 5.50 cents/share. The distribution decreased all the way to 4 cents/share by the end of 2007, while the stock price was around $3.71/share. Currently, the Fund is trading around $2/share, and pays a distribution of 1.50 cents/share. You can see that the yields remained high throughout the period. However, for investors who purchased in 1999 or 2004, the yield on cost is equivalent to anywhere between 2% - 3%. In addition, these investors would be sitting at huge unrealized losses.

Other companies who offer similar high yields today, with the prospect of lower distributions over time, include US oil and gas royalty trusts. These trusts purchase established oil and gas assets, and pay out all of the net cashflows to investors. Once the oil and gas wells that these trusts own are pumped out dry in two or three decades, there will be nothing left over. Furthermore, the amount of oil and gas pumped out every year will decline over time, and unless prices increase at much faster rates, distributions will be projected to decrease. This information is typically shown in securities registration statements filed with the SEC. Unfortunately however, many yield chasing investors do not bother reading prospectuses.

Compare this to a typical dividend growth stock where the company is committed to raising dividends per share out of earnings. This type of company is typically overlooked by many yield hungry investors. However, most dividend growth companies in the dividend achievers or dividend champions lists tend to follow a slow and steady approach to raising distributions. Over time, the stock price increases, and yield stays in the same low range. The yield on cost increases however, as evidenced by the high amount of dividend income received by our dividend investor.

Of course, improving fundamentals such as earnings per share are what truly provides the fuel behind rising dividends. Rising dividends is typically a byproduct of rising sales and income.

A few companies that fit the perspective of higher expected earnings over time, and higher dividends include:

The Coca-Cola Company (KO), a beverage company, manufactures, markets, and sells nonalcoholic beverages worldwide. Over the past decade, the company has managed to increase dividends by 9.80%/year, supported by a 7.90% annual increase in earnings. This dividend king has managed to increase dividends for 52 years in a row. Currently, the stock at the top range of valuation range for me at 19.60 times forward earnings. The stock yields 3% at present levels. At a 7% growth in dividends, yield on cost could reasonably be estimated at 11% - 12% in 2034. Check my analysis of Coca-Cola.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. Earnings per share increased from $3.32 in 2008 to $5.26 in 2013, while quarterly dividend amounts went up from 46 cents/share to 94 cents/share in the same time frame. Philip Morris International has managed to increase dividends for 6 years in a row. Currently, the stock is attractively valued at 16.20 times forward earnings and yields 4.50%. At a 9% growth in dividends, yield on cost could reasonably be estimated at 25%  - 26% in 2034. Check my analysis of Philip Morris International.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. Over the past decade, the company has managed to increase dividends by 9.90%/year, supported by an 8.60% annual increase in earnings. This dividend achiever has managed to increase dividends for 11 years in a row. Currently, the stock is attractively valued at 18.20 times forward earnings and yields 3.10%. At an 8% growth in dividends, yield on cost could reasonably be estimated at 14% - 15% in 2034.Check my analysis of General Mills.

ConocoPhillips (COP) explores for, develops, and produces crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids worldwide. Over the past decade, the company has managed to increase dividends by 15.70%/year, supported by a 6.20% annual increase in earnings. This dividend achiever has managed to increase dividends for 13 years in a row. Currently, the stock is attractively valued at 12.30 times forward earnings and yields 3.70%. At a 7% growth in dividends, yield on cost could reasonably be estimated at 14% - 15% in 2034. Check my analysis of ConocoPhillips.

Johnson & Johnson (JNJ), together with its subsidiaries, is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. Over the past decade, the company has managed to increase dividends by 10.80%/year, supported by a 7.20% annual increase in earnings. This dividend king has managed to increase dividends for 52 years in a row. Currently, the stock is attractively valued at 17 times forward earnings and yields 2.80%. At a 7% growth in dividends, yield on cost could reasonably be estimated at 11% in 2034. Check my analysis of Johnson & Johnson.

Full Disclosure: Long YUM, MCD, KO, PM, JNJ, COP

Relevant Articles:

- The number one reason why i don't chase high-yielding stocks
- Don’t chase High Yielding Stocks Blindly
- The Security I Like Best: Philip Morris International (PM)
- Yield on Cost Matters
- The Dividend Kings List for 2014