Yield on cost

What Is Yield on Cost?

Yield on cost (YOC) is a financial metric that measures the annual dividend income an investor receives from an investment relative to their original purchase price. Unlike current dividend yield, which uses the current market price, yield on cost provides a personalized view of an investor's actual income return based on their historical cost basis. It is a key metric within investment analysis for those focused on income investing and tracking the performance of a long-term portfolio that includes dividend-paying shares.

History and Origin

While "yield on cost" as a formal term may not have a singular historical origin, the concept has naturally evolved with the practice of long-term dividend investing. As investors began holding assets for extended periods, particularly those that consistently increased their dividends, they observed that the income stream, when compared to their initial outlay, became significantly higher than the current market yield. This organic growth in income became a powerful driver for strategies emphasizing dividend growth and the benefits of compounding over time. Over decades, investors recognized that steady dividend increases from a company, even modest ones, could lead to a substantial yield on their original investment, effectively providing a growing stream of income for a fixed initial capital commitment. This perspective is often discussed in forums and articles dedicated to long-term income-focused strategies, highlighting the compounding effect of reinvested dividends and consistent dividend increases from companies.

Key Takeaways

• Yield on cost reflects the annual dividend income relative to an investment's original purchase price, offering a personal return metric.
• It increases over time if a company raises its dividends, even if the share price remains flat or declines.
• Yield on cost is particularly relevant for long-term investors focused on growing their income stream.
• It helps illustrate the power of compounding and dividend growth in an investment portfolio.
• This metric can be significantly higher than the current dividend yield for investments held over many years with consistent dividend increases.

Formula and Calculation

The formula for Yield on Cost (YOC) is straightforward:

Where:

• Current Annual Dividend Per Share refers to the total dividends expected or received per share over a 12-month period.
• Original Purchase Price Per Share is the initial cost at which the investor acquired each share, including any commissions or fees.

For example, if an investor bought shares at $50 per share and the current annual dividend is $2 per share, the yield on cost would be:

Interpreting the Yield on Cost

Yield on cost is primarily interpreted as a measure of the effectiveness of an income-oriented investment strategy over time. A rising yield on cost for a particular stock or fund indicates that the dividend income generated from the initial capital outlay is increasing. This can be due to the company consistently raising its dividend payouts, which is often a sign of strong financial health and growing earnings.

For long-term investors, a high and growing yield on cost can signal a successful income-generating asset. It demonstrates how patience and the power of compounding can lead to a significant income stream relative to the initial commitment, potentially outpacing inflation and providing substantial passive income for retirement or other financial goals. When evaluating a security, a high yield on cost on an older position suggests that the investor's foresight or patience has been rewarded through rising dividends.

Hypothetical Example

Consider an investor, Sarah, who purchased 100 shares of Company X five years ago at an original purchase price of $30 per share. Her total initial investment was $3,000 (100 shares * $30/share).

At the time of purchase, Company X paid an annual dividend of $0.90 per share.
Sarah's initial yield on cost was:
(\frac{$0.90}{$30} \times 100% = 3%)

Over the past five years, Company X has consistently increased its dividend. Today, the annual dividend has grown to $1.80 per share.
Sarah's current yield on cost is now:
(\frac{$1.80}{$30} \times 100% = 6%)

Even if the current market value of Company X shares is $40, the current dividend yield would be (\frac{$1.80}{$40} \times 100% = 4.5%). Sarah's yield on cost of 6% is higher because it's based on her lower original purchase price, demonstrating how a growing dividend stream can generate an increasingly attractive income relative to the initial investment.

Practical Applications

Yield on cost is particularly valuable for investors pursuing a dividend growth strategy, where the primary objective is to build a rising stream of income over decades. It is used in several contexts:

• Retirement Planning: Retirees or those planning for retirement often use yield on cost to assess the future income potential of their portfolio. A high yield on cost means they receive a substantial income stream relative to their initial investment, which can help cover living expenses.
• Performance Tracking: It allows investors to track the success of their long-term dividend-focused investments, highlighting how much their personal income return has grown. This provides a different perspective than total return, which includes capital appreciation.
• Behavioral Reinforcement: Seeing a high and growing yield on cost can reinforce disciplined, long-term holding strategies, especially during periods of market volatility when the market value of shares might fluctuate.
• Tax Considerations: The dividends contributing to yield on cost are subject to taxation. Investors should be aware of how dividends are classified (e.g., qualified vs. ordinary) and their corresponding tax rates, as detailed by the IRS Publication 550: Investment Income and Expenses.³

Limitations and Criticisms

While yield on cost can be a motivating metric for income-focused investors, it has limitations and is not universally favored. One primary criticism is that it is a personal, historical metric that does not reflect the current market reality or opportunity cost. An investment with a high yield on cost might still have a low current yield for a new investor, or its total return (including capital gains) might be subpar.

Critics argue that focusing solely on yield on cost can lead to an irrational attachment to underperforming assets, especially if the share price has stagnated or declined, even as dividends grew. Some financial advisors and academics emphasize that total return — which combines dividend income and capital appreciation — is a more comprehensive measure of an investment's success. For instance, discussions among investor communities, such as those on the Bogleheads forum, often point out that dividends are merely a component of total return and that living off dividends is functionally similar to selling shares for income, particularly from a tax efficiency standpoint.

Fu²rthermore, a company might increase its dividend while its underlying business fundamentals deteriorate, leading to a high yield on cost but a significant decline in the market value of the equity. Over-reliance on this metric without considering the company's valuation and growth prospects can lead to suboptimal return on investment. The broader academic perspective on dividend policy also highlights that the decision to pay dividends is complex and influenced by various factors, including agency costs and firm characteristics, rather than solely indicating future performance.

##¹ Yield on Cost vs. Dividend Yield

Yield on cost and dividend yield are both metrics related to the income generated by an investment, but they differ significantly in their calculation and application, leading to common confusion.

Yield on cost offers a personalized historical perspective on an investor's income stream from a particular investment. It tends to rise over time if the company increases its dividends, making it a favorite metric for dividend growth investors. In contrast, current dividend yield is a standardized metric reflecting the dividend payment relative to the current market price, making it useful for comparing the income-generating capacity of different stocks at a specific point in time. While yield on cost can provide a sense of personal achievement and the power of long-term holding, current dividend yield offers a more objective, market-based snapshot of a security's income attractiveness.

FAQs

Q1: Is a high yield on cost always a good thing?

A high yield on cost is generally positive as it indicates a growing income stream relative to your original investment. However, it's not the sole indicator of a good investment. It's crucial to also consider the company's overall performance, capital appreciation, and any risks, as a high yield on cost could mask a stagnant or declining share price.

Q2: How does dividend reinvestment affect yield on cost?

Dividend reinvestment (DRIP) can significantly boost your yield on cost over time. When dividends are reinvested, you acquire more shares without additional cash outlay, effectively lowering your average purchase price for the increased number of shares. This means future dividend payments on these additional shares will further amplify your yield on cost.

Q3: Can yield on cost decrease?

Yield on cost will only decrease if a company cuts its dividend, or if the initial investment was made at multiple price points that effectively raise the average cost basis, assuming the calculation is re-evaluated for the entire position. However, if calculated strictly on the original single purchase price and the dividend increases or stays flat, the yield on cost will either rise or remain constant. A dividend cut, however, would directly reduce the "Current Annual Dividend Per Share" in the formula, thereby lowering the yield on cost.