Dividend Yield Theory

7207 Views 6 Replies 5 Participants Last post by Financial Highway, Apr 7, 2009

Max

Discussion Starter · Apr 5, 2009

I have been thinking a lot about dividend yields in a rising market, and something doesn't add up.

Scenario: I have a $10 stock paying a $1 annual dividend (10%). The stock price subsequently rises to $20. Am I still making a 10% yield?

Most of the dividend investors would say yes, but looking at it more closely, I say no.

I have a $10 capital gain whether it is sold or not sold, so to continue to hold the stock is to hold it at a 5% yield.

In this case, if I could buy a bond that yielded 8%, I am better off to sell my $20 stock and invest in the bond than to hold the stock even though it is still earning 10% on the initial $10 investment.

Conclusion: Cost is irrelevant in dividend yield. Market price is what determines the base of the yield equation. This causes me to doubt my set it and forget it strategy, since rising stock prices reduce my dividend yield to the point where I should consider selling them.

Any comments about this? Am I failing to consider something?

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mfd

· #2 · Apr 5, 2009 (Edited)

I know dividends4life focuses on YOC (yield on cost). He doesn't care about the value of the stock but the yield on the initial cost. I think that's whats important

Now there has always been debate if the dividend strategy should focus on growth or yield. Your example seems to focus on yield and ultimately you are right. Even the most devoted long term investors are open to selling a position if a better opportunity presents itself. Get out of the dividend and focus on the bond. However I think a good dividend strategy focuses on a balance between yield and growth as part of the evaluation process (this is something I think dividends4life does well). This makes sure that you never have to worry about bonds being worth more and your dividend income keeps up with inflation.

I know it probably wasn't the intention of your example but as a final point your example doesn't take into account that you'll get hit with capital gains on selling the stock and that the bond payout isn't taxed as efficient as dividends, unless of course its in a tax free retirement account then who cares.

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Financial Highway

· #3 · Apr 5, 2009

To me I think if the stock gains 50% based on fundamentals there is a very good chance that dividends will also increase so therefore your yield will be somewhat higher. If 50% gain is not supported by earnings than your point would make sense to get the gain and leave.

As a dividend investor, I am reluctant to sell out a position due to strong performance if the company keeps continuing to raise dividends and from the past almost all dividend paying companies i have held if increased payouts every year, well until last year.

The other point is that if you buy a bond or other stock yielding 8% you will most likely assuming more risk.

Lastly i think MFD brings up a good point about tax efficiency.

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lb71

· #4 · Apr 6, 2009

Max, your conclusion is somewhat flawed.

Your dividend yield is based on how much you paid for the stock. It does not matter if the stock rises to $20 or falls to $2, as long as it continues to pay out $1 your yield is 10% on $10.

You also have an unrealized capital gain of $10. Your total (unrealized) return is (10+1)/10 = 110%.

If the stock fell to $2, would you say your yield is now 50%? No, your yield is still 10%, but your investment has returned (-8+1)/10 = -70%.

Yes that bond is yielding more than the stock at current market prices (8% is more than 5%). So, if your intent is to invest in the highest yielding asset, then you would sell the stock and buy the bond. (Remember that there are tax implications too.) So even though you are earning a 10% yield, the bond's 8% yield is better because they are on two different basis. You would either have to convert the stock's yield to a current basis (5%) or the bond's yield to a prior basis (16%). Either way, the bond is better today.

Cost is the most important part of determining your yield. Rising stock prices increase the total return of your investment.

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seven3

· #5 · Apr 6, 2009

I kind of agree with the first post. In many articles we see calculations of yield based on the original cost.

However, what that doesn't take into account is the "Opportunity Cost". If my $10 stock goes to $20, I think we'd need to compare the yield based on $20 against other options...so yeah, I think we need yet another term The "opportunity cost" yield!

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Max

Discussion Starter · #6 · Apr 7, 2009

I appreciate the arguments on the side of cost basis yield. Good points.

1) Dividends on stocks are not permanently fixed, and can rise over time, which trumps any fixed yield instrument over time.

2) The scenario also applies to other stocks with a higher yield, and holding the stocks in an RRSP can alleviate the capital gain, but in the scenario as it was originall presented, taxes are indeed an important point to consider.

Yield on cost seems to be a psychological trap that could keep me invested in my original stock and to ignore better opportunities elsewhere by focusing more on past performance than future potential.

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Financial Highway

· #7 · Apr 7, 2009

seven3 said:
I kind of agree with the first post. In many articles we see calculations of yield based on the original cost.

However, what that doesn't take into account is the "Opportunity Cost". If my $10 stock goes to $20, I think we'd need to compare the yield based on $20 against other options...so yeah, I think we need yet another term The "opportunity cost" yield!

I think that is a valid point, but again as I mentioned earlier if the stock gains 50% based on fundamentals and earnings, than I do not see a need to change because they will more than likely raise dividends. However if the 50% gain is not supported by earnings, than I would take the profits and go elsewhere.

The other issue is that if you just go after yield you can get burned, because higher yield is "USUALLY" means higher risk, hence you will be taking on more risk for the yield.

Check out CC's post on dangerous of chasing yield

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