We’ve covered a lot of basics in the first five lessons. I’ve tried to make each lesson short and confine each one to a single point. But the knowledge is piling up. If you have been following along, you’re building a good foundation for being a great dividend growth investor.
Here’s what we’ve learned so far:
- What’s a dividend?
- Dividend growth
- The 5-year rule (about seeking a track record of rising dividends)
- The incredible power of compounding
- Turbo-charging your returns by reinvesting your dividends
In this lesson, let’s talk about two essential metrics in dividend growth investing: Yield and yield on cost.
Yield is one of the most common measurements in stock investing. Do you know what it is? Yield is the one-year percentage return on your investment from the dividend.
You buy a stock. The company issues dividends.
How much will they send you in the first year? You can measure this in dollars and cents.
Say your stock pays a dividend each quarter, and its most recent payment was $0.25.
That means that you can reasonably expect to receive dividends totaling $1 in the next 12 months: 4 x $0.25 = $1.00.
This is useful information, but there is a weakness in measuring dividends this way. You don’t know whether that $1.00 is a good, lousy, or average return on your investment. That’s because we did not consider the price you paid for that share of stock. We didn’t take into account the amount of money you gave up for the expectation of receiving that $1.00 in the next year.
Yield covers this weakness. The yield calculation takes care of it by accounting for price. The formula is Yield = 12 Months’ Dividends / Price.
Let’s say that you paid $10 for that share. With this additional information, now we know that the $1.00 you expect to receive equals 10% of the price of the share. That’s 10% return on your money in one year. Most people would consider that a very good return.
Most dividend growth stocks don’t pay that much. Dividend yields are more typically in the 2%-3%-4% range.
Here’s some fine print: There are several ways to compute yield, depending on what 4 quarters of dividends you use. If you use the past 4 quarters, that’s called “trailing yield.” It’s what has already happened.
As an investor, you are more interested in what’s happening now. Think of the speedometer on your car. You want it to read how fast you are going right now, not how fast you were going a little while ago.
So yield is usually computed by annualizing the most recent dividend payment, as I did above. The reasoning is that last payment is the company’s current “speed” in paying dividends.
So if the last quarterly payment was $0.25, as in the example above, the expectation going forward is that the company will pay out that amount each quarter. That is the yield you are getting (present tense). Therefore your yield would commonly be expressed as $1 / $10, or 10%.
Here’s a screen shot from Yahoo! Finance for Johnson & Johnson (JNJ), which I own. This is from the summary page for the stock as of a few days ago.
The very last item in the center column shows the dividend and yield for JNJ. As you can see, Yahoo! presents both the dollar amount and the percentage yield for the stock. They show the dollar amount as $2.64 (this is the annual total, not the quarterly installments).
You can check their yield calculation yourself: The stock’s price closed the day at $88.46 (shown at the top). $2.64 / $88.46 = 2.98%. They show 3.00%. I would say that their calculation is slightly off, or perhaps it had not been updated at the time I looked (a couple hours after the market closed).
In any event, the yield when rounded is clearly 3.0%. I just use yields to one decimal place anyway. Trying to be more precise than that is not worth the time involved, and the exact yield is changing constantly anyway as the stock’s price changes from moment to moment. Carrying it out to more than one decimal place is false precision.
Let’s look a little deeper at JNJ’s dividend, because it allows us to tie together lots of things we have seen in earlier lessons. From JNJ’s own website, here is a press release from April 25, when they announced their most recent dividend increase:
From this announcement, we can see the declaration date, payment date, record date, and ex-dividend date, all of which we discussed in Lesson 1.
We see that the declaration included a very nice dividend increase of 8.2%. This is the sort of dividend growth that we discussed in Lesson 2.
Note that the announcement points out that this is the 51st consecutive annual dividend increase for the company. That’s almost unbelievable. The streak started when Kennedy was president. They haven’t missed a year since! We talked about the importance of increase streaks in Lesson 3.
We see this line: “At the new rate, the indicated dividend on an annual basis is $2.64 per share…” This is the same figure used by Yahoo! So we know that Yahoo! is using the forward dividend, which as I said has become common practice and is the most useful figure for you. It is the current rate at which you are earning money.
YIELD ON COST
I began my demonstration Dividend Growth Portfolio in June, 2008. (It is coming up on its 5th birthday!)
The original amount in the portfolio was $46,783. I spread that across 12 stocks to get started. Each year, through the combined effects of dividend increases, reinvestment of dividends, and the magic of compounding, the dividend stream into that portfolio has grown.
This is a screen shot from my website, where I place a report card on the portfolio each month.
Notice the last column, Yield on Cost. What the heck is that?
Yield on cost is kind of like yield, except that instead of using current price in the equation for yield, we use the original amount spent. Yield on Cost = 12 Months’ Dividends / Original Price.
Yield on cost can be computed for an entire portfolio as well as an individual stock. For my Dividend Growth Portfolio, I never add new money from outside, because I want it to be a “pure” demonstration of the power of dividend growth investing. The only monies going into the portfolio are the dividends it receives.
Therefore I can compute the yield on cost of the entire portfolio by dividing a year’s worth of dividends by the original value of the portfolio. The original value never changes: It was set when the portfolio was established. So as the dividend flow increases, the yield on cost goes up relentlessly. That’s because the divisor in the equation never changes, while the numerator (the dividend flow) goes up all the time.
You can see the yield on cost for this portfolio marching relentlessly up in the last column. For example, it is currently projected that 2013’s dividends will total $2542. That’s a yield on cost of $2542 / $46,783 = 5.4%. Back in 2008 when I started the portfolio, the yield on cost was only 2.1%.
Some people criticize yield on cost as just a backwards-looking “feel-good” number. Here’s what I use it for:
- A check on how I am doing
When I began this portfolio in 2008, I set its mission: To yield, from dividends alone, 10% of its original cost. I found this inspiring, because 10% is about equal to the annual total return (including price) from the stock market since the Great Depression.
I am attempting to match that historical total rate of return from dividends alone by the end of 10 years.
I find that very inspiring, to think that I can create a dividend stream that by itself produces the same amount of money each year as the stock market historically returns in total (price + dividends).
The table above shows that I am on track. Without going into complicated mathematics, I have already increased the yield on cost from 2.1% in 2008 to an estimated 5.4% in 2013. At that pace, I will attain the target 10% in 2018, by the portfolio’s 10th anniversary.
Truth be told, 2013’s yield on cost will probably be even more than 5.4%, because (1) some companies in the portfolio have more dividend increases to announce in 2013, plus (2) I will make one or two dividend reinvestments before the end of the year. The shares purchased with those reinvestments will start contributing their own dividends soon after I buy them, jacking up 2013’s dividends still further.
One final point to wrap up this lesson. Please notice that saying that I want my portfolio to grow its dividend stream to 10% yield on cost after 10 years is exactly the same as saying that I want it to send me $4678 in dividends after 10 years. 10% of the original portfolio cost of $46,783 = $4678. The two ways of looking at the portfolio’s mission are mathematically identical.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks