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investor clinic

Every so often, I'll hear from an investor with a story that goes something like this:

Ten years ago, I bought shares of XYZ for $10 each. At the time, they were paying a dividend of 40 cents annually, for a yield of 4 per cent. Since then, the dividend has doubled to 80 cents, so my 'yield on cost' is 8 per cent. I couldn't possibly sell my XYZ shares now, because there's no way I could find a yield like that in the stock market today.

While the calculations are correct, there's a flaw in this argument, which I'll explain in a moment. First, let's review the concept of yield on cost.

The main benefit of calculating yield on cost is that it demonstrates the power of long-term dividend growth, as the following real-life example illustrates.

Back in October, 2003, shares of pipeline operator Enbridge traded at about $12 on a split-adjusted basis. The annual dividend was 41.5 cents a share, so the yield at the time was $0.415/$12, or 3.46 per cent.

Enbridge has hiked its dividend 10 times since then, and is now paying $1.26 a share annually – more than triple the dividend of a decade ago.

If you were fortunate enough to have purchased Enbridge 10 years ago, your yield on cost would therefore be the current annual dividend of $1.26 divided by the 2003 stock price of $12, which works out to 10.5 per cent. That's pretty nice.

I calculated the yield on cost for a few other blue-chip Canadian dividend stocks – assuming an investor purchased them 10 years ago:

  • TransCanada: 7.4 per cent
  • Royal Bank of Canada: 8.9 per cent
  • Fortis: 8.9 per cent
  • Telus: 11.3 per cent

These are the annual returns, from current dividends alone, that an investor would be getting today as a percentage of the original purchase price a decade ago. The numbers are impressive indeed, and they demonstrate how investors can profit by buying and holding stocks with rising dividends.

However, problems arise when an investor compares the high yield on cost of an investment purchased years ago with lower dividend yields available in the marketplace today. It is an apples-to-oranges comparison: The former measures the annual dividend as a percentage of the stock price at an earlier point in time; the latter measures the annual dividend as a percentage of the current stock price. Big difference.

Consider Telus. While it's true that you can't find a blue-chip stock yielding 11.3 per cent these days, if you'd bought Telus 10 years ago you wouldn't actually be making 11.3 per cent on your money today. The reason: Telus shares have risen nearly 200 per cent, so you now have a lot more money invested. And based on the higher value of your capital, your actual return from dividends is about 4 per cent – which is Telus's dividend yield.

That's not to say your original purchase price doesn't matter. If you hold a stock in a non-registered account, you need to know your cost base to calculate capital gains tax when you sell. However, taxes aside, having a high yield on cost is not, in and of itself, a reason to hang on to a stock.

You should judge your stock holdings based on expectations for future growth in the share price and dividends, not on a calculation that uses a number from the past.

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