Why would you not calculate your model dividend portfolio’s yield based on its book cost instead of its current market value?
I’ll calculate the yield both ways in today’s column. Then I’ll explain why I prefer one method over the other.
Let’s use my model Yield Hog Dividend Growth Portfolio as an example. This is an opportune time to do so, because the portfolio just reached a key milestone: Thanks to a 6-per-cent dividend hike from Capital Power Corp. (CPX) on July 30, the portfolio’s annual income has now officially doubled since inception.
When I launched the portfolio with $100,000 of virtual money on Oct. 1, 2017, it was throwing off $4,094 of income annually based on dividend rates at the time. Owing to scores of dividend increases and regular reinvestments of cash over the years, it’s now generating $8,199 of income – an increase of 100 per cent.
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Now, to your question about yield: The traditional way to calculate the yield of a portfolio or individual stock is to divide the projected annual income by the current market value. Dividing the model portfolio’s annualized income of $8,199 by its market value of $192,896 (as of July 31) produces a yield of about 4.3 per cent.
In other words, for every dollar of capital in the portfolio today, about 4.3 cents of income is being generated annually, based on current dividend rates. This is what is known as the “indicated yield,” and it is by far the most common way to calculate yield.
But some investors prefer to measure yield in a different way. They calculate the “yield on cost” by dividing current annualized income by the original cost of the stock or portfolio, not by the current market value. Using this method, the yield on cost of the model portfolio is $8,199 divided by the original value of $100,000, or about 8.2 per cent.
The main benefit of using yield on cost is that it illustrates the growth of income over time. Indeed, despite the tariff-related volatility that has swept financial markets this year, dividend increases have continued to roll in from utilities, power producers, banks, real estate investment trusts and other companies in the portfolio. This is one reason I invest in dividend growth stocks: They bring some stability and predictability to an uncertain world.
But here’s the problem: Some investors don’t always interpret yield on cost properly. They make the mistake of comparing the yield on cost with the current yields available in the marketplace. This is an apples-to-oranges comparison that can lead investors astray.
Let’s look at a stock in my personal portfolio to see why.
Back in 2010, I bought shares of the utility, Fortis Inc. (FTS). At the time, the stock was trading at $27.58 a share and paying $1.12 of dividends annually, for a yield of about 4.1 per cent.
Fortis (which I also hold in the model portfolio) has raised its dividend every year since then and is currently paying $2.46 annually. My yield on cost is therefore about 8.9 per cent (calculated as $2.46 of current income divided by my original purchase price of $27.58).
Some fans of using yield on cost might argue that I could never find a dividend yield that high in the marketplace, especially from a company as solid as Fortis. I’ve even seen investors use a high yield on cost to justify hanging on to a stock they might otherwise want to sell.
But am I actually earning 8.9 per cent on my investment in Fortis? No, absolutely not, because – this is the key part – my investment is no longer worth $27.58 a share. That price is 15 years out of date.
Thanks to steady appreciation in Fortis’s stock price over the years, my investment is now worth about $70 a share, as of Friday morning.
So, if I currently have about $70 of capital tied up in each Fortis share, and each share is generating $2.46 of dividends, the yield of my Fortis shares is actually 3.5 per cent, not 8.9 per cent. The higher yield is misleading because it is derived by applying a current dividend rate to an old share price, which makes it useless for comparing Fortis’s yield with the yields of other dividend stocks.
Let’s look at a more extreme example to drive the point home.
Imagine you purchased a rental apartment building 50 years ago for $100,000. At the time, the building was generating rental income of $10,000, for a yield of 10 per cent.
Now, let’s assume the apartment building’s market value and its total rental income have both increased tenfold, to $1-million and $100,000, respectively. Would you calculate the apartment’s yield by dividing the current rental income of $100,000 by the wildly out-of-date market value of $100,000? Of course not. The price you paid 50 years ago is no longer relevant.
What matters for the purposes of calculating the apartment’s yield, and comparing it with the yield of other apartments, is the property’s current market value and annual income potential today. The building’s true yield is therefore 10 per cent ($100,000 divided by $1,000,000).
A high yield on cost is a nice reminder that your income has grown, but it should never be used as a metric to compare with other investments. So, the next time someone tells you they don’t want to sell a stock because it has a high yield on cost, show them this column.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails, but I choose certain questions to answer in my column.