Dividends uncovered: Getting to grips with ‘yield on cost’

Julie Brownlee, Fsp Invest, 05 Jan. 2015

Tags: yield on cost, dividends, dividend, dividend yield, what is yield on cost, using yield on cost, income investors,

If you invest in dividend paying shares for income, the dividend yield is an important figure.

But there’s something else that you should also consider. That is ‘yield on cost’.

So what is yield on cost? How can you calculate it? And how can you use it?

Read on to find out…

Investing for dividends

If you’re an income investor, you’ll no doubt be familiar with the dividend yield.

To calculate the dividend yield you divide the current dividend per share by the current share price.

For example, Company ABC pays a dividend of 40c. Its share price is 1,000c. That gives it a dividend yield of 4% (40c/1,000c).

If a company is successful, its profits and dividends should grow over the long-term.

How to calculate yield on cost

Going back to our example, if Company ABC grows its dividend for ten years by 5%, at the end of year ten the dividend will be 65c.

So if you’d bought shares at 1,000c ten years ago, your yield on cost would now be 6.5% (65c/1,000c).

The yield on cost tells you the dividend return as a percentage of the price you paid for the shares.

The yield on cost calculation is useful if you’re investing for income. It allows you to weigh up different income investment opportunities.

How to use yield on cost

Let’s say Company ABC has company bonds that pay an interest rate of 5% today. It also offers a dividend yield on its shares at 3.5%. Analysts expect dividends to grow at 10% annually.

Weighing up these two income investment opportunities, the bond may look more attractive as you’ll get a higher income at first.

But the interest rates on bonds stays the same throughout the life of the bond.

If you buy the shares instead, the dividend yield is lower than the yield off the bond to begin with. Yet after four years of 10% dividend growth, the share will pay you a higher income on cost than the bond.

Of course, there are no assurances that the dividend will continue to rise 10% a year.

So there you have it, getting to grips with yield on cost.

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