The dividend yield is probably the most popular means of gauging the income produced by an investment. However, like most financial metrics, it doesn’t necessarily always tell the full story.
In this article, we’ll examine the yield on cost measure and why it may be a better method of determining personal portfolio yield.
What Is Yield on Cost?
Yield on cost is the annual dividend paid by the security divided by the original cost basis of the investment. It is different from the dividend yield, which measures the annual dividend against the current price of the security. Since most securities rise in value over time, the yield on cost is often, but not necessarily, higher than the current dividend yield.
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How Is Yield on Cost Calculated?
Let’s look at the example of an investor who bought 100 shares of XYZ Company stock five years ago at a price of $20 per share. Currently, it has a share price of $40 and pays a $2 per share annual dividend.
The dividend yield on the stock would be the $2 dividend divided by the current $40 share price, or 5%. The yield on cost would be the $2 dividend divided by the original cost basis of $20, or 10%.
If the investor purchases additional shares of XYZ, the cost basis of the investment would need to be adjusted. For example, let’s say the investor purchased another 100 shares at the current price of $40. The new cost basis of the total investment is: ((100 shares * $20) + (100 shares * $40)) / 200 shares, or $30 per share. Therefore, the new yield on cost would be $2 divided by $30, or 6.67%. The dividend yield remains at 5%.
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Is Yield on Cost a Useful Measure?
The big question is whether or not yield on cost adds any informational value beyond what the dividend yield provides. In many ways, the yield on cost is a “feel good” measure. Investors like to look at their account statements and feel like they’re earning 10-20% annually on their original investment. While this is true, it may not give an accurate portrayal of how the security is performing currently.
On the plus side, yield on cost can provide an indicator of dividend growth. Assuming that no additional share purchases are being made, the cost basis of the investment remains constant. If a company grows its dividend at a 5% annual rate, that increase will show up in the yield on cost. It may or may not be easily ascertainable looking at the dividend yield because the share price regularly moves up and down.
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On the downside, the yield on cost only takes into account the dividend paid by the company and doesn’t look at total return. Using the previous example, if XYZ stock dropped to $10 per share, the shareholder would have lost 50% of the principal value of the investment. In this scenario, the yield on cost would remain the same and may give the perception that shareholders are still enjoying returns. In reality, the shareholder has suffered a significant loss.
Further, the company may have cut the dividend down partially or completely in light of the likely financial turmoil the company experienced that caused its stock price to drop in half. Investors should be aware of the limitations of the yield on cost metric and understand that, like the dividend yield, it doesn’t necessarily paint the full picture.
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The Bottom Line
The yield on cost is another number that can be useful to investors in certain ways. Like most figures, it needs to be used in conjunction with other common financial metrics to give a better idea of the overall health of an investment.
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