In Lesson 6, we learned about yield on cost. Specifically, we learned that yield on cost means to compute your portfolio’s yield based on the original amount spent rather than its current value:
Yield on Cost = Next 12 Months’ Dividends / Original Price
In this lesson, I am going to use yield on cost to show you how you can achieve a wonderful goal: To receive, each year, in dividends alone, an amount of cash that equals the market’s long-term average annual total return.
This seemingly impossible result comes to you through the courtesy of two important phenomena that we have already discussed:
- The dividends provided by dividend growth stocks (Lesson 1: What Is a Dividend?).
- The annual increases in dividends from each good dividend growth company (Lesson 2: Dividend Growth).
How to Get to 10% Yield Return in 10 Years
The 10 by 10 concept is simple: It is a goal to create a portfolio that yields, in dividends alone, the average historical total return of the market, which is about 10% per year. And to get to that point in 10 years.
Those are the two “10s.” The first “10” refers to the 10% yield goal. The second “10” represents the 10 years to get there.
OK, let’s drill down a little.
Let’s say that your portfolio has only a single stock. The following table shows what combinations of initial yield and annual dividend growth would enable you to reach the 10 by 10 goal with that single-stock portfolio.
The numbers in the table represent how many years it takes to get to 10% dividend yield, given a particular initial starting yield (top axis) combined with various dividend growth rates (left axis).
The shaded area in the table covers the yield + growth combinations that get you to the 10 by 10 goal. If the number in the table is 10 years or less, that means you can get to the 10 by 10 goal. That is, you will reach 10% yield on cost in 10 years or less.
Note that with a 2% initial yield, you cannot get to 10 by 10 under any reasonable dividend growth scenario. The number of years to get to 10% yield on cost, starting with a 2% yield, is 12 years even with an optimisitic 15% per year dividend growth rate. No number of years in the 2% yield column is 10 or less, and so none of that column is shaded. (That’s the reason that in my own investing, I look for an initial yield of 3% or maybe just a trifle less.)
On the other hand, if you get a 5% initial yield, there are lots of dividend growth rates that will get you to the 10% yield goal within 10 years. Any dividend growth rate of 6% or more will do it.
A Cheat Sheet about Initial Yield, Dividend Growth Rate, and Yield on Cost
When you first start a portfolio, its initial yield is the same as its yield on cost. Say your portfolio has just one stock, and that its current yield at the time that you buy it is 4.0%. Its yield on cost is also 4.0%, because neither the expected dividends over the next 12 months nor the value of the portfolio have changed yet.
Over time, both change. If the stock increases its dividends each year, the expected payout of dividends goes up. And of course, every day that the market is open the stock’s price changes. So the portfolio’s yield on cost soon departs from its initial yield.
The initial yield when you first purchase a stock is known at the time you buy it. If the company does not cut its dividend, your yield on cost will never drop below that initial amount. I like to say that your initial yield on cost is “locked in.”
The same cannot be said about the dividend growth rate, however. You can look at the recent history of a dividend growth stock and see, for example, that its 5-year dividend growth rate has been 10% per year for the past 5 years. However, if you project that into the future, you are speculating. No one knows what the future holds.
So use the 10 by 10 table with a dose of common sense. Particularly if a company has a 5-year dividend growth rate that is quite high (say > 10%), understand that it will be difficult or impossible for the company to continue to increase its dividend that fast every year. You might want to use a more typical rate, like 6% or 7%, when you are making future projections.
On the plus side, if you are reinvesting dividends, the number of years to hit your target yield on cost will be reduced. The additional shares purchased with reinvested dividends will themselves pay dividends. Thus you will see a faster increase in the dividend stream –and in the portfolio’s yield on cost – than if you did not reinvest the dividends.
Let’s use my own demonstration Dividend Growth Portfolio (DGP) as an example. The portfolio was started in June, 2008, and I reinvest dividends. My goal with this portfolio is the 10 by 10 goal.
The chart below shows the DGP’s current yield vs. its yield on cost.
At the very beginning, the portfolio’s yield and yield on cost were identical, as we discussed above.
It took about a year for the portfolio’s current yield (the blue line) to settle down. Now it stays pretty constant at around 4%. (By the way, a current yield of about 4% is very typical for a dividend growth portfolio.)
But as the red line shows, the yield on cost just climbs higher and higher. It has reached 5.9% after 5 years, well on its way to reaching the 10%-in-10-years goal that I have for this portfolio.
Notice that the 5.9% yield on cost is a full 48% more than the portfolio’s current yield of 4.0%. Why is the yield on cost so much more than the current yield? The reason is that the yield on cost is computed on the original investment that I made in the portfolio 5 years ago. In its first year, 2008, the DGP delivered a yield of only 2.1%. That is mainly because I started the portfolio on June 1, 2008, so the first year’s yield only represented a partial year’s worth of dividends.
But the portfolio’s yield on cost has now ballooned to a current run-rate of 5.9%, or more than 2.8 times what it delivered in its first year of existence. The dividend stream has increased not only because the companies in the portfolio have been raising their dividends, but also because I am reinvesting those dividends to buy more shares. This brings the magic of compounding into play (see Lesson 4, The Power of Compounding), and reinvesting the dividends will lop a couple of years off the time that it takes me to get to my goal of 10% yield on cost.
Takeaways from this Lesson
- It is very realistic and possible to create a portfolio that will return, in dividends alone, the historic total return of the stock market, and to achieve this in 10 years or less.
- This goal is known as 10 by 10: That means generating a yield on cost of 10% within 10 years of when you start the portfolio.
- The 10 by 10 goal is achievable because of two factors: The initial yields on the stocks you buy, plus the dividend growth rates of those stocks. For example, a stock yielding 5% when you buy it will reach 10% yield on cost in 10 years if it increases its dividend 7% per year.
- You can get to the 10% yield goal even faster if you reinvest dividends.
- All of the above is true even if the current yield of your portfolio flat-lines, as it probably will (due to the increasing dollar value of your portfolio). The yield on cost will continue to march relentlessly higher as your companies raise their dividends, and as you reinvest them.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks