We’ve covered a lot in the first five lessons. The knowledge is piling up.
Here’s a quick review of the most important points.
- A dividend is a distribution by a company to its owners, usually in cash.
- The ex-dividend date is important, because it determines who gets the next dividend. If you buy a stock before its ex-dividend date, you’ll get the dividend. If you wait until the ex-date or later to buy the stock, you won’t get the next dividend.
- The only requirements to be a “dividend growth” stock are that a company (1) pays a dividend and (2) grows it each year.
- Dividends are determined by company policy and are therefore independent from the market. A company’s dividend can go up while its price is going down. It happens all the time.
- As of early 2018, more than 800 companies traded in the USA have increased their dividends for 5 years straight or more. Over 100 of them have done it for 25 years or more.
- The 5-year Rule is an investing guideline that a company must have raised its dividend for at least 5 years straight in order to buy it.
- A company’s track record is not foolproof. Therefore, other due diligence is required before investing.
- Compounding means earning money on money already earned.
- Companies compound their dividends by raising them each year. Each raise is on top of prior raises.
- Compounding causes your income to go up at an accelerating rate each year.
- Reinvesting dividends adds a second layer of compounding on top of the companies’ dividend increases.
- Reinvesting dividends buys new shares, which produce their own dividends, in a repeating cycle of growth and reinvestment.
- Reinvesting accelerates the speed at which your dividends compound.
- You can reinvest to add to companies you already own, or to start positions in new companies.
Now let’s move forward to discuss two essential metrics in dividend growth investing: Yield and yield on cost.
Yield is the one-year percentage return on your investment from the dividend.
Yield is measured in percentage, in order to make yields comparable across different stocks.
Each company, of course, pays dividends in money – dollars and cents. But knowing only the dollar amount doesn’t tell you whether the return is low or high, because you don’t know how much you had to pay to get that dividend.
Yield answers that question.
Say your stock pays a $0.25 dividend each quarter per share. That means that you can reasonably expect to receive dividends totaling $1 in the next 12 months for each share you own: 4 quarterly payments x $0.25 each = $1.00.
Is that good or paltry? You don’t know, because that knowledge does not reveal how much the stock costs. How much are you paying for the right to receive that dividend?
Yield covers this weakness by accounting for price. The formula is simple:
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 a 10% dividend return on your money in one year. So the yield would be stated as 10%.
Most dividend growth stocks don’t yield that much. Dividend yields are more typically in the 2%-5% range.
Here’s the 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 and likely to happen going forward. We want the “forward yield,” which is sometimes known as the “indicated yield.”
Forward yield is computed by annualizing the most recent dividend payment, as I did above. I took the most recent quarterly payment and multiplied it by 4. That gives me the expected next-12-month total (assuming the company doesn’t change its dividend in the meantime).
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) if you buy the stock right now.
Caution: Not every data source uses the forward yield. For example, Morningstar looks backward in their main display:
The stated yield for Dominion Energy is 4.8%. But that is actually the trailing yield discussed above. (Morningstar does not label it, but that’s what is displayed.)
Morningstar shows the forward yield, correctly labeled, further down the page:
Note that the difference is significant. The trailing yield – 4.8% – has already happened. The forward yield – 5.15% – hasn’t happened yet, but it is what will happen provided that Dominion doesn’t cut their dividend in the next 12 months.
Let’s look at another common source, Yahoo Finance.
Yahoo is very clear about what they are showing: The forward yield. Note how they annualized the dividend (to $3.34 per year), which is proper, because yield is an annual return.
The lesson here is simply to be careful. Find out the calculation method of whatever source you are using. You want to be consistent in comparing yields, so the same calculation method should be used whenever you are making such a comparison.
In my writing, I always use the forward yield unless I specify otherwise. The reason is that I want to know what dividend return I can expect going forward, not what happened last year.
Yield on Cost
Yield on cost is the yield based on the original price paid instead of current price.
Here is the formula:
Yield on Cost = 12 Months’ Dividends / Original Price
Yield on cost (YOC) can be calculated for an individual stock or an entire portfolio.
Here is an example of an individual stock. In my Dividend Growth Portfolio, I purchased 30 shares of Johnson & Johnson (JNJ) in 2010 at a cost of $58.00 per share. JNJ’s current dividend is $0.84 per share per quarter, as shown by the red outline in this image from E-Trade.
I multiply that quarterly dividend by 4 to get JNJ’s annual dividend: $0.84 x 4 = $3.36 per year per share. Then the yield on cost equation is…
Yield on cost = $3.36 / $58 = 5.8%
That means that I am receiving 5.8% of my original purchase price back from JNJ in the form of dividends each year.
As shown by the blue outline, JNJ’s current yield is 2.6%. That’s figured on JNJ’s current price, not the $58 that I paid for it in 2010.
Yield on cost demonstrates that I am receiving a higher dividend return based on the price I actually paid for my JNJ shares than the current yield would indicate.
Now here is an example of figuring the yield on cost of a whole portfolio. My Dividend Growth Portfolio began with a value of $46,783 back in 2008. I have never added another dime, so the original value never changes.
So as the dividend flow increases over time, the yield on cost goes up regularly. That’s because the divisor in the equation never changes, while the numerator goes up when companies raise their dividends or I buy more shares with the dividends I receive.
As of the end of 2017, the forward 12-month expected total dividend on my portfolio was calculated (by E-Trade) as being $3836. Therefore, for the whole portfolio…
Yield on cost = $3836 / $46,783 = 8.2%.
That means that I was receiving 8.2% of the portfolio’s original value back from the portfolio each year in cash.
Caution: Some people criticize yield on cost as just a backwards-looking “feel-good” number. They say that it simply shows what has already been accomplished via dividend increases since you paid the original cost.
It is true that YOC is like looking up at a scoreboard, in that it shows what has already been accomplished. It really does not come into play in making current investment decisions.
However, I don’t find YOC to be useless. Here’s what I use it for:
- A check on how I am doing
When I began the Dividend Growth Portfolio in 2008, I set its mission to generate a growing income stream over time. That can be measured either in dollars or by its yield on cost.
I found it inspiring, and still do, to think that 10 years after it started, the portfolio could be returning to me, in cash, 8% of its original cost each year.
And obviously, since YOC is a “scoreboard” statistic, it’s a fast way to state how the portfolio is doing on its mission.
Key Takeaways from this Lesson
- A stock’s yield tells you how much it will return to you in dividends per year, expressed as a percentage of its current price. Yield = 12 Months’ Dividends / Price.
- Forward yield – based on a stock’s current annual payout – is more useful than its backward yield.
- A stock’s yield on cost (YOC) tells you how much it will return to you in dividends per year, expressed as a percentage of your original cost for the stock. Yield on Cost = 12 Months’ Dividends / Original Price.
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