Is this the best metric for income investors?
This week's episode looks at a little known metric that may help income investors
This week's episode looks at a metric that income investors may be overlooking - yield at cost.
Let's start with a comparison and definition. The dividend yield is a measure of how much an investor can expect to receive in dividends at the current price if the dividend is maintained. We calculate a dividend yield by dividing the dividend paid over the last year by the current share price. If a share is trading at $20 and paid a $1 dividend the yield is 5%.
The yield at cost ignores the current price and instead looks at the cost basis. If you purchased the same share at $10 that paid a dividend of $1 the yield at cost is 10%.
This episode explores why this matters for investors, and how it may help investors that are looking past current yield, and looking to find investments that may generate a larger cash flow as time passes.
You can find the full article here, or listen below.
Listen on:
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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
Mark LaMonica: So, we're telling ourselves before we record this, we need to be high energy.
Jayamanne: We're both very tired today.
LaMonica: Yes. You had to wake up very early and drive your parents to the airport.
Jayamanne: Yes. Why are you tired, Mark? Because – I mean, we're recording this on the 7th of November. And yesterday was the U.S. election.
LaMonica: I mean, I guess one thing I'm tired of is like every Australian is coming up and asking me what I think.
Jayamanne: Well, what do you think?
LaMonica: I'm certainly not going to talk about what I think on the podcast. But I don't know. I think people should stop asking me that question.
Jayamanne: Okay.
LaMonica: I don't know. I mean, I'm like the token American. And before the election, everyone's like, who do you think will win? It's like you're reading the same newspapers as is me, why do I have different information?
Jayamanne: Everyone really wants to know your thoughts on the election.
LaMonica: Apparently, apparently. But I'm not going to give them.
Jayamanne: Okay. What are we going to do instead?
LaMonica: We're going to do the episode. So, today, we're going to do an episode on a single data point.
Jayamanne: We're really scraping the bottom of the barrel. Mark, we’ve been doing these episodes for a while.
LaMonica: Well, we have. So, yeah, we do these every week. We have to come up with a topic.
Jayamanne: Could people please send in some episode suggestions? We're struggling.
LaMonica: I think it's going to be a good episode. But I was the one that came up with this topic.
Jayamanne: I mean, I assume that it's a very well-known data point that you're going to use. I'm sure it'll add a lot of value for listeners.
LaMonica: I mean, listen, I would describe it as a little used and virtually unknown data point. But I use it.
Jayamanne: Okay.
LaMonica: I think it's really helpful and useful for me. In terms of valuable for listeners, I think they'll have to determine that if they're still on at this point, but…
Jayamanne: This is like the investing version of the Secret.
LaMonica: It's not the Secret. Like, I'm willing to talk about it. Unlike my views on the election, I'm willing to talk about this data point.
Jayamanne: Okay. This is a lot of suspense. Do you want to just tell us what the data point is?
LaMonica: Yield at cost, Shani.
Jayamanne: Okay.
LaMonica: So, I think given the way that you're looking at me, it's probably helpful if I describe what it is, why I think it's useful and why I use it so much. So, I talk all the time about how I'm an income investor on here. Income investors, obviously, talk about yield a lot, Shani. So, you, of course, calculate the yield with the dividend and the current share price. So, if the dividend is $1 and the share price is $20, the yield is 5%. And of course, that yield always changes, right. Because dividends can potentially change, but the share price is always fluctuating.
Jayamanne: And many income investors do use this data point to find shares. That way they know if they invest a certain amount of money, they will get a certain amount of income. But of course, most of the time we hear backward-looking dividend yields because the dividend payments are those received over the last 12 months, and anything can happen in the future.
LaMonica: Yeah. That's right. And that's really important. But even with these limitations, many investors are interested in the yield. And of course, it does have some value. But before talking about yield at cost, my data point, it's worth talking about how I see income investing and my goals. So, my goal is to create a growing stream of passive income. That's because I want to spend that income on things that I want in my life. So, I do spend some of it now, as we’ve talked about, and I plan on spending some of it in the future. But when I think about that income stream, what really matters to me is, of course, what I can purchase with it.
Jayamanne: And that is where inflation comes in, which is critical for all investors to think about. As we are all too aware lately the price of goods and services go up, over time, which is why the money that comes in needs to go up. That is either growing salaries, appreciating assets, which can be sold in the future to pay for things, or in Mark's case, a growing income stream.
LaMonica: Yeah. So, that's right, Shani. So, the yield at cost takes a historic look at what I saved and invested and calculates the yield on those investments. So, instead of taking the current share price of something I hold, I look at the cost basis or price I paid for the share.
Jayamanne: So, that's easy enough to calculate. In our example of the share with the $1 dividend and $20 share price, you'd instead use the purchase price. So, if you paid $10 for that share, the yield at cost would be 10%.
LaMonica: Yeah. And so, what this allows me to do in using that case, I could say that if I invested $1,000 in that share, my investment is now generating $100 in income. So, to fully understand why I use this, we need to talk about the three ways to grow passive income. So, one way is dividend growth. So, a share that you hold increases dividends over time. That's a great outcome. The second way is to reinvest those dividends. We'll get to the third way in a second. So, a little teaser for the third way.
Jayamanne: So, I assume you've incorporated this into your view of yield at cost?
LaMonica: I have. I have. You're very sceptical about...
Jayamanne: I'm not sceptical at all. I trust your judgment.
LaMonica: Well, thank you. That's like the nicest thing you've ever said to me in real life or on this podcast.
Jayamanne: Well, it's been recorded, so you can replay it over and over again.
LaMonica: Before we started filming this and recording this podcast, I made a comment about how I looked horrible in the last one. And you said, that's just how you look.
Jayamanne: I didn't. I just said you look like Mark.
LaMonica: So, basically, that's how I look. Anyway, let's talk about how I incorporate that second measure, right. We have the growing dividends, how I incorporate those reinvestment of dividends. So, what I do is I reduce my cost basis for the shares I own as I reinvest dividends. So, I'll use a basic example. We'll go back to that original example and just build on that.
So, in it, I purchased 100 shares at $10 a share. The dividend growth is, of course, captured by using the current dividend of a $1. But let's say I also reinvested those dividends I received over time. Let's say I now own 150 shares. So, I still paid $1,000 for my shares, and I own 150 of them. So, in my model, that drops my cost basis from $10 to $6.66.
Jayamanne: Alright. So, I'm going to play devil's advocate here.
LaMonica: I'm shocked.
Jayamanne: So, you technically reinvested all those dividends. Each dividend that was reinvested was cash you received that you could have done anything with. And instead, you reinvested it. And it's important to point out that the ATO does take a different view. The cost basis for the first 100 shares is the $10 that you paid. The cost basis for each share purchased with the dividend reinvestment is a price that each dividend was reinvested at. So, that's actually good because if the share was rising, the cost basis is higher and you pay less taxes.
LaMonica: Okay. You are, obviously, 100% correct, as you normally are. Let me talk about this ATO question first because you did say a couple of different things. So, that is true. And this whole yield at cost that I use is not meant to, obviously, change or misinterpret tax law. So, yeah, I mean, if I could change taxes, I just wouldn't pay any, right. Like that would be the easiest thing to do. But I'm not using this as a way to calculate the taxes that I owe. I'm using this because I want metrics that I can use to guide my behavior, and which force me to focus on things that I believe will lead to a good outcome.
Jayamanne: It's worth noting that we do this stuff all the time. You can call them tricks or whatever you want, but we do come up with ways to get ourselves to do the right thing.
LaMonica: Yeah. So, that's certainly true. So, I think it's worth talking about why I do this and what I get out of it if anyone's still listening to the yield at cost episode. So, there is a problem with using current yields to judge a security if you're an income investor and that is that generally what they are is they drive people to swap out one share for another. I can go through a bit of an example.
So, let's say CBA is yielding 2.75% and NAB is yielding 5%. A lot of investors, income investors would say, okay, I should sell my CBA shares and then buy NAB shares, I get more money, right. That at a very superficial level may be what people do, but there are all sorts of reasons not to do that. So, one reason is, of course, taxes. I would have to pay tax on the CBA shares that I sold, assuming they've appreciated. There are transaction costs, but really the issue is, is it gets back to my goal. So, my goal is to grow my passive income. So, I need to focus on dividend growth. I need to constantly remind myself that growth matters. So, we're going to go back 10 years, Shani. So, in 2014…
Jayamanne: What were you doing?
LaMonica: Well, 10 years ago, I moved to Australia. So, 10 years ago, I had been in Australia for two months. I still don't know what I was doing, alright. I know I was in Australia as I still am. But going back 10 years, 2014, maybe I was doing this. So, CBA paid a dividend of $3.99 a share. CBA currently pays a dividend of $4.65 a share. So, that is more, as people obviously know. 2014 NAB paid a dividend of $1.98 a share. Currently NAB pays a dividend of $1.68 a share. That is less. So, my point is simply that using a measure that shows me what matters to achieve my goals is really helpful to me.
The fact that it doesn't line up with the ATO is kind of besides the point. I'll pay my taxes if I sell something and I'll calculate it in the correct way, but the behavior I want is to not sell things that are doing what I want them to do, which is growing dividends. I just want to make sure that for every investment, every time I buy something, that the success – hopefully success, but the success or failure of that investment is measured in a way that, ultimately, reinforces what I want.
Jayamanne: So, let's get back to this concept around dividend reinvestment. I understand what you're trying to do, but maybe go into it a bit more about the dividend and how an investor should consider the dividend not as a cash flow, but directly attributed to the share you own and lowering the cost basis. We know that many investors don't do a direct dividend reinvestment, but instead collect them and just buy separate shares.
LaMonica: Yeah. Yeah. No. Exactly. So, yes, each dividend is a distinct cash flow. I happen to directly do dividend reinvestments for shares I own when I'm not spending the money. So, it just buys new shares of that share that I hold. But I do completely understand your point.
Getting that dividend is, to me, a direct consequence – even though it's this separate cash flow, it's a direct consequence of me purchasing the share in the first place. I think what is good about reinvesting dividends, no matter how you do it, is the fact that they compound. And let me run through an example. So, I used a very simple example before and just said the shares I start with and the shares I end up. But let's dig into the compounding element a bit.
But for Shani, compounding is used all the time. I feel like people don't actually know what they're saying, though, some people. So, why don't you …
Jayamanne: Who are you referring to?
LaMonica: I'm not referring to you. I'm referring to some people in general. So, why don't you remind everyone what compounding is?
Jayamanne: Okay. Compounding is simply earning a return on a return. I'll use an example from just a share price appreciating. So, let's say you bought a share price at $100. If that share price goes up 10%, your investment has increased by $10. Let's say it goes up 10% a year for 10 years. Now the share is $259.37. Well, in year 11, if the share price also goes up 10%, your gain is now $25.93. And that is a power of compounding. You're now earning returns on returns. That is why the same 10% gain in the market now gets you $25.93 instead of $10.
LaMonica: So, that was a very good description, which hopefully is helpful. But I'm going to try to do the same thing, but I'm going to talk about dividends. So, we talked about those two sources already that you increase your passive income, increase in dividends and dividend reinvestment. So, let's model this out.
Let's say you have a share trading at $100 at a 5% yield. So, therefore, it pays a $5 dividend. In this example, the dividends increase by 10% a year. So, there's focus on the dividends there. Your passive income has gone in that same 10-year example, starts at $0.50. In 10 years of 10% growth, the dividend is now $12.97.
Jayamanne: This sounds like the same example.
LaMonica: Well, I wasn't finished yet. So, you’ve got to give me a second. Alright. So, the same example part is the dividend goes up another 10% in year 11, right. Your income has now increased by the same percentage, but you get $1.29 instead of $0.50. Alright. So, let's assume you've reinvested the dividend at the end of each year and that the share price has also appreciated by 10% a year. So, it means you have this constant yield. This is just an example. Obviously, this doesn't happen, but it's a constant and the concept is important. You have this constant yield. Well, over that 10 years, the number of shares you own has, obviously, increased because you're reinvesting those dividends. So, you no longer have one share, you now have one and a half shares. That means that the dividend you are paid is not $12.97, it's $19.45. It means on an annual basis, the dividend still went up 10%, but your passive income increased by $2.35.
Jayamanne: So, it's compounding on steroids?
LaMonica: Yes, which is something I've never been accused of.
Jayamanne: Compounding or steroids?
LaMonica: Steroids.
Jayamanne: Okay.
LaMonica: You know, like finance bros that wear t-shirts that say like always be compounding?
Jayamanne: No. I don't know any people like that.
LaMonica: Maybe we have a different set of friends.
Jayamanne: Okay. Are we done yet?
LaMonica: We aren't.
Jayamanne: Okay.
LaMonica: I have one more thing to say about yield at costs. So, you asked about a shareholder, they didn't reinvest dividends automatically, instead just got those dividends and then invested them in whatever they wanted. They still reinvested them just not in that same share. Well, you can also measure yield at costs on a portfolio. So, how much you've saved and how much income your portfolio is generating would be that measure.
Jayamanne: And one thing that I think is worth pointing out is that almost all returns you see assume the reinvestment of dividends. I just think people don't realize that sometimes unless you see the return specifically reference price returns.
LaMonica: Yeah. I mean, that is a good point. And it was nice of you to make it, right, because you do want to end this podcast. Clearly, I can see it in your eyes for one thing. But I'll say one more thing and then we can finish this off.
So, I referenced the fact that there are three ways your passive income grows. So, we talked about dividend growth. We talked about dividend reinvestment. Well, the third way is, of course, just saving and investing more money. That is really what yield at cost is all about. So, it allows me to compare how I've done with investments in different holdings. That is the reason I like it.
Sometimes dividend growth will be so high that a low-yielding share turns out to be the best investment for passive income. And that's my theory. I think we talked about it here. I purchased CSL a couple of years ago, which has a very low yield. But that was my theory with that. So, yield at cost could validate that hypothesis. Sometimes what really matters is buying a higher yielding share that has lower growth. But that higher yield more than makes up for it. So, I just think this is a good way to compare different investments in your portfolio, and once again, just reinforce that behavior I was talking about.
Jayamanne: Are we done?
LaMonica: We are done, Shani.
Jayamanne: Okay.
LaMonica: Sorry for keeping you. I'm sure you have something. You saw you have a photo shoot this afternoon that I'm sure you're dying to get to.
Jayamanne: Not really, no. But we've traveled into the wells of yield at cost. If you have any episode ideas or suggestions, please email Mark at the email.
LaMonica: On a completely unrelated note, we will be doing interviews for our new co-host on Investing Compass if anyone wants to apply. But thank you very much for listening. Really appreciate it. My email address where you can send those suggestions and comments about this episode is in the show notes. Thanks for listening.
