Yield is basically just a fancy term for return on investment. However, “Yield” and “Yield on Cost” (YOC for short) are two related terms that I see confused, conflated, and generally misunderstood by way too many people and way too often. This usually happens when someone fires off an article or blog post saying how dividend growth investing is a terrible idea. Familiarizing yourself with the difference between these two terms is easy and very important to understanding the world of dividend growth investing.
First the definitions
- Yield - The dividend that a stock pays as a percentage of the stock’s price. For the mathematically inclined: Dividend/Price * 100
- Yield on Cost (YOC) - The dividend that a stock pays as a percentage of what you paid for the stock. For the mathematically inclined: Dividend/PurchasePrice * 100
Yields change rapidly over time as stock prices fluctuate
Let’s say that you’re sitting on the sidelines watching Pepsi (PEP).
About the time I wrote this, PEP was trading at $69 per share. PEP paid out an annual dividend of $2.15 per share. $2.15/$69 * 100 = 3.12%. If PEP has a really bad month and the price drops to $60 per share the yield is now $2.15/$60 * 100 = 3.56%. But one month later the markets recover and PEP is up to $72 per share which makes the yield $2.15/$72 * 100 = 2.99%.
To summarize the PEP yield example above:
- Day 1: $2.15 dividend at a $69 share price = 3.12% yield
- Day 30: $2.15 dividend at a $60 share price = 3.56% yield
- Day 60: $2.15 dividend at a $72 share price = 2.99% yield
Factors affecting yield
Yield is affected by only two factors which you should be able to easily guess from the above equation.
- Dividend payments - One of the reasons why I like to buy stocks with a 10+ year history of dividend increases is that their dividend payments are likely to continue increasing over time.
- The current market price of the stock.
YOC changes much more slowly over time
The key point of YOC is the OC part (on cost). Once you make an investment in a stock, your cost is fixed. You spent the money, now you’ve got the stock. As such, your primary concern is how much the stock is paying you compared to the price you paid for the stock.
Let’s say that you bought PEP when it was trading at $69 per share with an annual dividend of $2.15 per share. You have now committed to the stock and your interest is no longer the stock’s yield but rather it’s YOC. Your starting YOC at the time of purchase is $2.15/$69 * 100 = 3.12%. This should look familiar.
Now let’s continue our example of YOC. One month later PEP decreases to $60 per share. Your YOC is still 3.12%. One month later PEP increases to $72 per share. Your YOC is still 3.12%. The YOC does not change because neither the price you paid for the stock nor its dividend have changed.
To summarize the PEP YOC example above:
- Day 1: $2.15 dividend at a $69 purchase price = 3.12% YOC
- Day 30: $2.15 dividend at a $69 purchase price = 3.12% YOC
- Day 60: $2.15 dividend at a $69 purchase price = 3.12% YOC
Note that as a prudent investor you should also be concerned about capital gains, but if your intent is to buy a dividend paying stock, hold it forever, and live off the dividends then capital gains become a less critical factor.
Factors affecting YOC
YOC is affected by several factors, listed below. The first two are pretty obvious. The last two are probably not so obvious, but they are the law of the land according to the accounts and IRS – so suck it up.
- Commission fees - If you paid $10 in commission to buy the stock, that commission fee is part of the total price you paid to purchase the stock.
- Dividend increases or decreases - The purchase price of the stock is static. But if the dividend payout increases over time, then the YOC increases as well. Of course, if the dividend gets reduced or eliminated then the YOC decreases.
- Premiums received from option sales - If you sell a cash secured put and are assigned the stock, then the premium is deduced from the purchase price and your YOC is increased. Same goes for selling covered calls – premiums collected are deducted from your cost.
- Material changes in the company - Sometimes companies split up or undergo some other kind of material change in their structure which may affect the purchase price of the stock.
Disclaimer: At the time of this writing, I have no position in PEP nor am I considering one.
Readers: Have you seen people confuse yield and YOC? Do you know of any other factors that affect yield or YOC?