There are some expressions used that I just don’t get. Maybe it’s me that’s way off, or maybe those that mention it don’t know what they’re talking about. Today, I mentioned one of those in a newsletter that I sent out and wanted to get your thoughts on another one. I’ve seen this one mentioned several times on blogs, but even in discussions with friends. Before giving you my opinion, in case you don’t know, dividend yield on cost is generally described as: -the annual dividend paid out by a company / average cost of that position
In some cases, it could be perceived as useful by some dividend-focused investors. If you buy a stock for $50 that pays a $1.50 dividend (3% yield) and that over 5-10 years that dividend increases to $3/year, some would say that the yield on cost is now 6%. In a way, it does represent the fact that the investment probably did very well. The stock increased its dividend by 100% and its price also likely increase significantly. If the yield remains at 3%, the stock would now be worth 100% more.
So yes, I could see how the average cost would be “useful” in such a context.
But tools to analyze stocks should work most if not all of the time. There are countless examples where this does not work as well. Take that same stock described earlier and imagine that the company is struggling. Yes it did increase the dividend over the years but it is also paying out more than what it is making (payout ratio > 100%). In such a scenario, the stock price would have decreased significantly.
So yes, both stocks would have a 6% dividend yield on cost… but they can’t be compared.
Average Cost Is (Mostly) IrrelevantThere is one big reason why I look at my average cost; taxes. When trading in a taxable account, average cost does make a difference in trying to determine if a position should be closed, especially near year-end.
But otherwise? Not in a million years. If I purchased a dividend stock 10 years ago in a taxable account and it pays out a 3% dividend yield, I would evaluate it in the same way as any other stock no matter if I’m up 10% or down 50% on the stock, it’s irrelevant. Yes, from a psychology standpoint, it’s difficult to sell a stock and make a loss “official”, we always hope the trade will revert. But in most cases, it’s a big mistake to hold on to a stock for those reasons.