Why you should understand YOC (Yield On Cost)

November 13th, 2008 · 2 Comments

Did you know that GE is currently promising an annual dividend yield of 7.35% based on today’s closing price of $16.86?   While that’s a pretty high dividend rate right from the start, things look even better if you start to think about GE’s long history of raising the dividend.  Admittedly, this is based on assumptions, but it is conceivable you could be earning a 19.07% annual dividend yield on your original investment in 2018 if GE maintains its recent 10% annual dividend growth.  And that’s before taking into account any compounding by reinvesting your dividends!

Beyond looking at large percentage growth numbers, which *everyone* likes to see, why does this matter?  Well, compare it to the sort of yield you’d be getting if you had instead put your money in a savings account, CD, or even a money market account.  For sake of discussion I think we can agree that an annual yield (i.e. interest rate) of 6% seems like the high-end for any of those types of accounts, and that seems consistent over long periods of time.  In an apples-to-apples comparison with the GE investment, where we’re not reinvesting and thus not compounding the interest each year, you’d still only be making a 6% yield in 2018.

This, admittedly extreme, exercise is called doing a Yield On Cost comparison.  Basically, YOC is used to measure and compare investments based on how their yield changes over time.  Think about it, your cost basis never changes for a given investment once you’ve bought into it so what really defines the potential passive income from that investment is how the yield changes.  And all investments are definitely not equal in that regard.  Sometimes it might be better to acquire the investment with the currently lower yield if you have confidence that it will achieve a higher YOC in a reasonable amount of time.  (Please keep in mind that a forecasted YOC is not a guarantee and a YOC based on past performance is also not a guarantee of future performance.  But then neither is the interest rate on most savings accounts.  Nor do you completely escape risk by going with bonds.)

This whole discussion is *not* trying to convince you to dump all your cash holdings into dividend paying stocks like GE.  No, those assets have very different risk profiles and thus have different useful purposes.  Where you should be considering YOC is when comparing investments of the same asset type, for example one equity versus another equity.  The more alike the asset types, the more relevant a YOC comparison might be.

Why am I not including compounding in this comparison?  Well, for one thing it is pretty difficult to confidently predict how many shares your stock dividends will buy along the way.  Secondly, if we’re talking about using the generated passive income to live on, you can’t reinvest the dividends or interest anyway.  And lastly, it seems somewhat obvious that a yield that grows over time is going to trounce a static yield, or even a slower growing yield, when you apply compounding.

By the way, how realistic is my annual 10% dividend growth rate forecast for GE?  While I can’t promise you anything, I can look at GE’s dividend history where it’s easy to note a long, steady trend of dividend increases.  A little simple math shows the following average annual growth in the quarterly dividend payout for the noted periods.  These periods aren’t based on anything other than when GE has completed stock splits.

Period Start Period End Average Annual Growth Rate
Fall, 1995 Fall, 1997 6.32%
Fall, 1997 Fall, 2000 16.40%
Fall, 2000 Fall, 2008 10.78%

This shows an average growth rate over 10% for 11 of the past 13 years.  While I’m only comparing quarterly dividend payouts instead of full annual payouts, it’s easy to see that since the dividend hasn’t decreased over this period of time that the growth in full annual dividend payouts won’t be much different.  In fact, this other site makes it a little easier to see the latest 5-year trend, which is 9.998%.  If the past did predict the future, I’d be pretty confident in my 10% dividend growth forecast!

Tags: Equities · Passive Income

2 responses so far ↓

  1. 1 davmp // 2008.11.15 at 5:52 pm

    An interesting an related blog posting: http://www.moneyandmarkets.com/dividend-superstars-crushing-other-income-investments-2-27664

  2. 2 davmp // 2008.11.21 at 11:39 am

    For future reference, GE is now using the blog at http://www.gereports.com/ to communicate with investors.

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