In most cases, investors use the dividend yield to determine how much income a particular investment is generating. It’s a simple measure of the annual dividend paid by a security to its current price. Some investors also like to use the yield on cost, defined as annual dividend divided by the original cost basis, as an additional metric to evaluate how well they’re being paid.
In this article, we’ll examine yield on cost in comparison to dividend yield and assess how it can be used to evaluate dividend stocks.
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Advantages of Using Yield on Cost
The yield on cost can be useful in assessing how productive an existing investment has been at providing income in the past. If you’re looking to see how much income you’re receiving based on your original investment, yield on cost is a way of determining that. Yield on cost is also an easy way to gauge the dividend growth of stock investments retroactively.
For example, consider an investor that purchased stock in XYZ Corporation at $100 per share. At the time of purchase, the stock was paying a $2-per-share annual dividend, translating to a 2% dividend yield. If the company increases its dividend by $0.10-per-share annually for the next 10 years, the stock’s yield on cost has steadily increased to 3%. Since the original investment remains constant (assuming no additional purchases are made along the way), a consistently rising yield on cost indicates that the company has been successful in raising its dividend over time.
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Disadvantages of Using Yield on Cost
Critics of the yield on cost metric will argue it’s a backward-looking measure that fails to consider relative dividend payments in the current environment and could mask the impact of negative corporate events such as a dividend cut.
Consider an investor who bought ABC stock several decades ago at $10 per share with a $0.20-per-share dividend. Over the years, the company has continued to grow its dividend all the way to $2 per share, producing a yield on cost of 20%. ABC has come up on tough times and has had to trim the dividend back to $1.50. The investor may perceive that all is fine since they are still receiving 15% annually on their original investment. In reality, a dividend cut often portends trouble within the company and the stock price may have already dropped significantly to reflect that. Going forward, this stock may no longer be a suitable investment.
Along those same lines, the yield on cost, like the dividend yield, is not a total return measure. Depending on the study, analysts generally conclude that somewhere between one-third and one-half of a stock’s total return comes from dividends. That leaves a large chunk of return attributable to share price movement. Higher yields don’t necessarily equate to better stocks. In fact, the opposite can often be true. In short, it’s not wise to judge how attractive a stock is based solely on a yield figure.
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Is Yield on Cost a “Feel-Good” Number?
While yield on cost can be useful in assessing the dividend history of a stock, is it a number that should be used in evaluating a stock? Stocks with long histories of increasing and paying dividends are often able to continue their track record. In that sense, yield on cost can be helpful in identifying dividend aristocrats and other long-term payers. It can also help in comparing the dividend characteristics of stocks over time.
Find out all the companies that have increased their dividends for more than 25-consecutive years, in our 25-year dividend-increasing stocks page.
Some will say that yield on cost is nothing more than a number that’s meant to make investors feel good about their investments. Individuals may be earning a yield on cost of 50% or more on their original investment, but that doesn’t represent the current value of the position, which could negatively impact portfolio decisions going forward. For instance, investors assuming that they’re earning a 50% yield in an IRA, when in reality they’re only earning a 4% current yield, could end up drastically misestimating how much they can spend in retirement.
Yield on Cost Can Be Misused
One of the biggest dangers in applying yield on cost is using it in relation to dividend yield. The two figures create an apples-to-oranges comparison that can be damaging to long-term portfolio returns.
For example, an investor owns shares of PPP Corporation that over time have created a yield on cost of 10%. He may be interested in CCC Corporation stock but sees that it pays a dividend yield of 3%. He makes the decision to stay with PPP assuming that he’d be earning three times as much in dividends. In reality, PPP may only sport a dividend yield of 2% and, based on the overall investment thesis, have poorer prospects than CCC.
When using yield on cost, investors also need to make sure they’re adjusting their cost basis when purchasing new shares. Using only the original price in the calculation misrepresents the overall cost basis of the investment and can lead to believing that the stock is performing better than it actually is.
Stay up to date with the highest-yielding stocks and their latest ex-dividend dates on our High Dividend Stocks by Yield page.
The Bottom Line
Yield on cost can be a useful metric when evaluating dividend stocks, but investors need to understand its limitations and how to use it correctly. Yield on cost can help in identifying long-term dividend growth history – an investing strategy intriguing to many income seekers. It’s not, however, a good indicator of current income potential. Investors need to make sure they’re not mixing the use of yield on cost and dividend yield so as not to risk making faulty portfolio decisions.
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