I’ve described yield on cost as the life-blood of the dividend growth investor. A dividend growth investor seeks out companies which have a history of raising their dividend yields every year without fail. Consistency in raising dividends is extremely important for a dividend growth investor as we count on increasing dividends to combat inflation through out the years and bulk up our dividend income, which will eventually be used to live off.
What is Yield on Cost?
According to Investopedia,
Yield on cost is an investment‘s annual dividend divided by the original purchase price of the investment.
A simple enough description. The yield on cost for every dividend growth investment is expected to grow, hence the name, dividend growth investing. If you follow my stock analyses, you’ll notice that yield on cost has it’s own separate section because it is a very important factor for me to look at before I make an investment. In fact, according to The Dividend Beginner stock picking strategy, a stock must have a 10-year YOC of at least 6% to pass my selection criteria.
WHY: The whole point of dividend growth is so that later in life you can reap rewards from the seeds you planted TODAY. If I’m not getting a yield of at least 6% in 10 years from now, then I’m not generating a ton of future cash flow in relation to my investments today.
How to Earn a Strong Yield on Cost
You can scoop up companies with a strong YOC in two different ways.
- Buying shares in companies who’ve had their stock price reduced by a large percentage usually have a large yield due to the share price reduction. This will allow you to have a larger starting yield, which, combined with dividend growth – will earn you a strong YOC.
- Buying shares in companies who have a high dividend growth rate (I like companies with double-digit dividend growth); despite their current yield, with a high dividend growth then the yield will increase as time goes by and earn you a strong YOC.
My most recent analysis of National Bank of Canada (NA) depicts how NA’s high starting yield and mid-to-high dividend growth rate work together to earn investors a strong YOC. Let’s check out exactly how this works out as an exercise for dividend beginners. First let’s lay out all the metrics which are important in observing an expected yield on cost.
Calculating Yield on Cost
|National Bank of Canada|
|Dividend Yield (starting yield)||5.87%|
|5-Year Dividend Growth Rate||10.03%|
|10-Year Dividend Growth Rate||8.86%|
*Numbers are from Feb 15, 2016.
The dividend yield is easily calculable by dividing the annual dividend by the current stock price.
Dividend yield = $2.16 / $36.79 = 0.0587 * 100 = 5.87%
The dividend yield of 5.87% will be our starting yield, since that is how much percentage we would receive in dividends from our investment on an annual basis. So, what we want to know through an expected yield on cost is: how much will our investment be paying us in 10 years based on the money we’re investing today?
To figure this out, we can use either the 5- or 10-year dividend growth rates in our calculations for an expected yield on cost. Sometimes it’s more prudent and cautious to lower these growth rates depending on the company’s well-being and the state of the economy. For simplicity’s sake, let’s figure out what our expected 10-year yield on cost would be using both the 5-year and 10-year growth rates for comparison.
We can calculate expected yield on cost like this
Yield on Cost = ((1 + Dividend Growth Rate / 100)Years of compounding) * Dividend Yield
So given this equation, let’s calculate the expected 10-year yield on cost based first on the 5-year dividend growth rate of 10.03% and then based on the 10-year dividend growth rate of 8.86%. Considering 8.86% is smaller, and spans a wider range of years, it is a more conservative estimate.
Using the 10-year dividend growth rate
dividend growth rate = 8.86%
years of compounding = 10
dividend yield = 5.87%
Yield on cost = ((1.0886)10) * 5.87 = 13.72%
Using the 5-year dividend growth rate
dividend growth rate = 10.03%
Yield on cost = ((1.1003)10)*5.87 = 15.27%
Remember, Remain Cautious and Conservative
Provided, with the state of the Canadian economy and the potential oil and housing risks attributed to the Canadian banks, it’s possible the dividend growth rate may slow down or even be suspended, as nothing is guaranteed when it comes to dividends – however we’re making an educated guess when we calculate expected yield on costs.
This is one reason I really adore companies which have dividend growth programs / plans or expectations, some such companies are Telus (T) and Transcanada Corp. (TRP); with this information it’s easier to calculate an expected yield on cost. However, one must be aware of companies which will announce their expectations to raise dividends and then cut them out of the blue, as Kinder Morgan did – angering many investors.
What do my fellow investors think about yields, dividend growth rates, and yield on costs? What combination do you strive for when choosing your investments?
I’ll be adding an “Expected Yield on Cost” calculator sometime in the future to this site, as I could not find a good one that fit this strategy well. Be sure to subscribe to The Dividend Beginner newsletter to have the release sent to your e-mail inbox.