Tuesday, February 27, 2018

Yield on Cost

We all know that by normal convention, yield is calculated as the annual dividend/coupon/interest amount divided by the current price of the security, which is current yield. However, some investors, instead of using current price, used the entry price as the denominator. This is also known as yield on cost. They would prefer to look at this version of yield as they wanted to know the returns based on their initial investment amount.

For example, a person bought Company A’s shares at $1.00 a few years ago. Fast forward to the present day, the share price had risen to $1.50.  If the current year dividend was $0.15, the “normal convention” would be $0.15/$1.50 = 10%, but to him/her who uses yield on cost, it would be $0.15/$1.00 = 15%.

Do note that for yield on cost, we would have to take in two major considerations. The first would be the inflation effect. Assuming he/she bought the shares at $1.00 each back in end 2010, and with a 3% annual inflation rate, the new cost at the end of 2016 (for six years) would be about $1.19. Using the above example, the yield would actually be $0.15/$1.19 = 12.6%.

The second major consideration would be the factor of capital gain/loss. What if the share price dropped to $0.80 and the dividend is at $0.20? It would be $0.20/$1.00 = 20% for him/her, which looks good, but (not taking inflation into play here) there is a capital loss of $0.20. Of course, any investor would have noticed it, but if one concentrates on this yield only, the capital loss would be like the elephant in the room that was not addressed.

Whether an investor wants to look at current yield or yield on cost, it is entirely up to his/her preference.

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