Dividend Yield-On-Cost Takes Stupid Impulses Out of Investing

Among almost any academic investor that you could possibly meet, the notion of caring about yield-on-cost is quickly dismissed as fool’s play; the hallmark of an unsophisticated investor.

What is yield-on-cost, and why is it so quickly dismissed?

There are two types of yield on cost: dividend yield-on-cost, and earnings yield on cost. It’s a comparison between what a company’s business performance is doing for you right now and the amount of cash you had to set aside to make that investment happen.

I’ll use the most famous investment in North America–Warren Buffett’s purchase of 400,000,000 shares of Coca-Cola—as an example.

From 1988 through the early 1990s, Warren Buffett spent $1.3 billion gobbling up shares of America’s signature soft-drink company, Coca-Cola (and because of the size of Buffett’s investment, he was unable to reinvest the dividends into more shares of Coke even if he wanted to do so).

As we flash forward to 2014, those 400 million shares of Coca-Cola could be sold for a little over $16 billion. That information is very useful if you want to sell your ownership in the business for obvious reasons, but it doesn’t tell you about the actual current business performance of Coca-Cola.

At the time of this writing, Coca-Cola is generating $2.08 in profits for every share that you happen to own, and the Board has elected to pay $1.22 of those profits to shareholders in the form of a cash dividend. It pays out about 60% of its profits to current owners, and keeps 40% of profits on hand to grow the business so that it can pay more dividends and generate more overall profits so that the stock price will go up over the long-term for its owners.

Applying that to Buffett’s sizable investment, we can see the following: the 400,000,000 shares represent $832 million in profit from selling Coke, Diet Coke, Fanta, Hi-C, Dasani, Vitamin Water, Minute Maid, Powerade, Sprite, Smart Water, and Mello Yellow, among hundreds of others across the globe. More tangibly, those shares represent $488 million that will get sent out in cash dividends to Berkshire Hathaway’s headquarters at Kiewit Plaza in Omaha.

What does the yield-on-cost signify for those figures? Based on Buffett’s $1.3 billion investment, his dividend yield on cost is 37.53% (488/1300) and his earnings yield on cost is 64% (832/1300). It’s a great way to see how the passage of time and business growth make the initial amount of money that you set aside to invest in a stock work harder and harder on your behalf.

It’s usually dismissed as a mental gimmick because you aren’t actually receiving a 37% dividend yield if you buy the shares today, but rather, it’s the 2.9% yield that the shares are yielding now that is significant if you are making buy or sell decisions. Also, financial advisors have a fear that investors will act to their detriment by holding a collapsing security if they refuse to part with something that is paying half as much in total dividends as you initially invested in the stock.

But for the very reasons most academics hate it, I happen to love it because it’s a way to get you to focus on actual business performance instead of stock price. If you bought Johnson & Johnson for $62 in 2012, you have no idea what idea what the business has done if you only focus on the fact that the price of the stock has increased to over $100 per share. Have business profits increased 65%? Are investors more willing to capitalize profits at a higher rate than they were two years ago? Are people losing their minds?

Instead, I like to look at what my money is doing over time as it relates to the business performance of the company. That’s what is durable. That is what is self-sustaining, and with non-cyclical companies, less subjects to whims in the economy. Stock prices are nothing but the bandwagon fans that raise things up and get interested when the team is doing well, and say cyanara as soon as times get a little bit tough (in the case of Johnson & Johnson, that meant a whole lot product recalls at its factories).

In the case of Johnson & Johnson, someone that bought 100 shares at $62 per share was earning $5.10 in net profits and receiving $2.40 in dividends. Your dividend yield-on-cost was 3.87% and your earnings yield-on-cost was 8.22%. Where are we now in 2014? Johnson & Johnson is going to generate $5.90 per share this year, and based on the recent dividend hike to $0.70 per share, you will be receiving $2.80 per share in dividends. In just two years, you’re slowly inching up—that $6,200 you set aside is now giving you 4.51% in annual cash based on your investment, and by the end of this year, Johnson & Johnson will be generating 9.51% of your purchase price in overall profits each year. The amount you set aside is slowly but surely becoming more effective.

Who wouldn’t want to reach the promised land of investing where setting aside $10,000 in a company becomes such a growing ownership stake that it one day starts generating $10,000 in profits per year, and eventually, starts paying you as much in dividends as you originally invested into the company?

I see it as the ultimate chill pill in long-term investing—imagine if reached a point where you achieved a 50% dividend yield on cost investment at the start of 2007. How could you worry about cratering prices during the recession when you received as many dividends in 2007 and 2008 from your stock investment as you invested in total into the company? It’s a lot easier to handle a stock falling in price from $60 per share to $30 per share if you collect in cold, hard cash the total amount that you invested into the company during the scope of that price decline.

Long ago, Warren Buffett had a great quote about how we’d all be greater investors if we had a punchcard that only allowed us to make twenty total investments over the duration of our lifetime. It makes you focus on what you do. As a corollary to that, I’d try to create a game: Find twenty investments you can make in your life in which you can get your yield-on-cost above 100% so that you can automatically reach the Cooperstown of investor; you know how hitting 3,000 hits in a career pretty much gets you into the Hall of Fame automatically? Well, you automatically make it into the investor’s Hall of Fame if you buy a stock that gives you your entire purchase price back as a cash dividend over the course of a year. And it has the great effect of keeping your head focused on the right thing: the business performance of your companies, and the amount of cash that you get to receive each year for being an owner. It’s the best way to measure the long-term, productive use of a particular pool of money. You’re not going to panic sell something that you’ve sedulously bought $15,000 worth of the stock and are set to receive $8,000 back in the form of a dividend over the course of the year. The entrenchment of yield-on-cost investing is a safeguard against impulsive selling just because the price declined.