The yield on cost debate rages on, and like many arguments there tends to be a lot of ambiguity between the perspectives and positions of the combatants. In other words, both sides are debating, in this case, Yield On Cost, but they are in actuality arguing about entirely different concepts. This is because each is approaching the issue coming from different embarking points. Consequently, there is rarely any resolution or meeting of the minds, each side walks away believing they have made their case, and therefore prevailed.
David Crosetti recently published an article that was chosen as an Editor’s Pick and featured on the front page of Seeking Alpha: “Is Yield On Cost Really Important to Dividend Investors?”
David’s article was well written and made a valid case against investors becoming too zealous with their embracing of the concept “Yield On Cost.” His core argument, as I read the article, was that current yield was a more important consideration for dividend investors than yield on cost. He did not say it in exactly those words, but it was the main takaway I got out of reading it. Frankly, I don’t disagree with that position if maximum income is your goal. On the other hand, I do not feel that David’s position negates the true value of the concept YOC (yield on cost).
To me, the real value of any investment metric is its ability to provide enlihtenment regarding the investment process. In this regard, I believe that yield on cost is an extremely important investing concept to use and understand that offers investors major benefits. However, like any investing metric, at least in my opinion, it is virtually worthless if used in a vacuum or in isolation. To me, yield on cost, like all investing metrics and ratios, are only valuable when looked at and utilized in relation to other metrics. More precisely stated, YOC is but one element that prospective investors should take into consideration before investing.
The Procter & Gamble versus McDonald’s Illustration
David Crosetti utilized a comparison between Procter & Gamble (PG) and McDonald’s (MCD) in his excellent article where he offered both a back test review and forward forecast on the dividend growth of each of these dividend champions. Since I am long both of these companies, and therefore very familiar with each, I duplicated David’s work through the lens of our fundamentals analyzer software tool, F.A.S.T. Graphs™. What I discovered was both interesting and illuminating, and therefore, inspired me to share what I discovered, and offer it as an adjunct and expansion to David’s good work.
An Expanded Look at David’s Back Tests
David Crosetti ran his back tests over the 13-year period beginning in January of 1999. When running my own back test I was able to very closely replicate David’s numbers with only very modest differences, which were more than likely due to timing and rounding. However, I did discover some very interesting and important metrics that I felt David’s article failed to consider in his comparisons of these two dividend champions - McDonald’s (MCD) and Procter & Gamble (PG).
To be clear, what follows is not meant to be critical of David’s article, because I believe his points were important and well taken. Instead, my objective is to offer additional insights into what other metrics investors need to measure before investing. In my opinion, yield on cost is an important investor consideration whether the objective is income, growth and income or total return. However, it is but one of many that should be evaluated. As David suggested in his article there is often a great deal of confusion as to the relevance of yield on cost: “But many people seem to be confused as to its value and its proper use in looking at our portfolios.”
Valuation Before Yield On Cost
When looking at Procter & Gamble and McDonald’s in January of 1999, as David did, it was immediately apparent that both of these dividend champions were overvalued (orange arrows). As David pointed out, Procter & Gamble was trading at approximately $45 a share, however, its intrinsic value was between $21 and $22 per share. McDonald’s was trading at approximately $38.41 and its intrinsic value was approximately $19-$20 per share. Therefore, a quick look at the historical graphs and the accompanying performance reports on each corroborates David’s thesis presented in his article.
On the other hand, each of these companies’ respective earnings growth rates (green circles), their starting PE ratios and of course the impact of overvaluation, are all additional considerations that needed to be evaluated. Moreover, in addition to yield on cost (orange box - the % return column on the dividend cash flow table), consideration should also be given to the total return differences that each company generated on their shareholders’ behalf.
Note that the return calculations show dividends and the growth of the yield over time, but not reinvested. I believe this provides a clearer picture of the precise return that each investment generated and where the return came from. It’s interesting to see that Procter & Gamble (PG) generated the most dividend income between the two, but significantly less capital appreciation, resulting in a total return that was approximately half of what McDonald’s (MCD) generated.
What a Difference Valuation Makes
When reviewing the above historical graphs, there were some obvious changes that occurred with each of our example companies. First of all, after 1999 and up through 2002, both of our companies experienced reconciliation with their valuations, Procter & Gamble’s stock price moved to alignment with its historical PE ratio and McDonald’s became moderately undervalued.
Also, Procter & Gamble continued to consistently grow their earnings while McDonald’s experienced some modest weakening of earnings growth. On the other hand, after 2002 we can see that Procter & Gamble continued its normal growth with maybe a little bit of additional cyclicality blended in, while McDonald’s, on the other hand, experienced a significant acceleration in earnings growth.
When both of these companies are looked at over the shorter 9-year time frame starting in 1999 up to current time, we find a significantly different perspective on the importance and value of the yield on cost metric. Now, instead of examining two companies with similar average growth rates and where both of them are overvalued, we find two companies with entirely different attributes. Procter & Gamble (PG) is arguably reasonably valued at the beginning of 2003, and McDonald’s (MCD) is moderately undervalued. Moreover, Procter & Gamble continues to give us historical earnings growth that is consistent with its longer-term norm, while McDonald’s is offering a period of accelerated earnings growth.
Therefore, the yield on cost scenario that we saw over the longer time frame first measured above has remained approximately the same with Procter & Gamble. However, the much more rapidly expanding yield on cost that McDonald’s generated, thanks to an accelerated earnings growth rate, coupled with an expanding payout ratio, materially distinguishes its dividend benefit from Procter & Gamble’s. Because McDonald’s, again thanks to low valuation, starts out 2003 with a higher yield that is growing much faster, the total income it generates for shareholders is more than double the level that Procter & Gamble shareholders received over this 9-year period.
Even more striking are the effects that all these metrics taken together have had on total return. If an investor had the foresight to buy McDonald’s when it was undervalued at the beginning of 2003, the rewards would have obviously been exceptional. A rapidly expanding yield on cost definitely contributed to McDonald’s strong performance, and therefore needs to be recognized and understood for its contribution to total return. Furthermore, the yield on cost level achieved, and the total income generated from a better valuation level are extraordinary.
Looking to the Future
Now let’s move to looking to the future as David Crosetti did in his article. The consensus analyst’s estimated 5-year growth rate for each of our companies is approximately the same. Procter & Gamble’s estimated growth rate by 22 analysts reporting to Capital IQ is 9.5%, and McDonald’s estimated growth rate by 26 analysts reporting to Capital IQ is 10%. David used a 10% earnings growth rate for both companies in his original article, therefore, the expected results will be slightly different, but within reason, the same. Also, David calculated 13 years forward, our tool allows us to go out 10 years.
As you examine the following forecast graphs, take note that the situation between these two companies has essentially flip-flopped regarding valuation. Currently, Procter & Gamble appears to be precisely fairly valued, while McDonald’s appears to be moderately overvalued. Moreover, since the growth rates of earnings are now very similar, any increase on yield on cost will happen at approximately the same rate. However, Procter & Gamble, thanks to its better valuation, has a current yield advantage and therefore should generate a greater level of total dividend income.
Also, the total return advantage now appears to be with Procter & Gamble, again thanks to better valuation, even though its earnings growth rate expectation is slightly less at 9.5% versus 10%. Consequently, I would classify Procter & Gamble as a conservative buy today, and McDonald’s as a fully valued hold. In other words, I do not believe McDonald’s is overvalued enough to sell, but on the other hand, I would like to see McDonald’s stock price in the mid to high 70s range before I would consider it a buy.
Procter & Gamble: Estimated Earnings and Return Calculator
Procter & Gamble: 10-year Earnings Yield Estimates
When reviewing the following “Earnings Yield Estimates” graph note that the blue shaded columns represent dividends and the growth thereof. The white column titled: “Target Prc Est Tot Return” provides estimates of future price and total return potential based on achieving the consensus analyst estimates. The green columns represent earnings and earnings yield for each forecast year. The yellow columns offer a comparison to riskless treasury bonds offering a perspective of risk.
McDonald’s: Estimated Earnings and Return Calculator
McDonald’s: 10-year Earnings Yield Estimates
When reviewing the following “10-year Earnings Yield Estimates” graphs note that the blue shaded columns represent dividends and the growth thereof. The white column titled, “Target Prc Est Tot Return” provides estimates of future price and total return potential based on achieving the consensus analyst estimates. The green columns represent earnings and earnings yield for each forecast year. The yellow columns offer a comparison to riskless Treasury bonds offering a perspective of risk.
Conclusions
I believe that yield on cost is a very valuable tool that can help investors make sound and prudent long-term investing decisions. However, how it’s used depends a great deal on the goals and objectives of the investors using it. In other words, an investor looking for maximum current income might look at yield on cost differently than the investor who is more interested in future income. Furthermore, investors trying to evaluate total return potential may look at it even differently again.
For example, let’s assume an investor is expecting to retire in the next 5 or 10 years. Based on the amount of capital they have available for investment they determined that they need a 5% yield on their capital. However, when evaluating yield availability, they discover that the class and quality of investments that they are willing to invest in are only offering a 2½% or 3% current yield today. With a simple calculation, they determine that their yield on cost would need to increase by approximately 10% per year (yield would double in 7.2 years at 10%) in order to reach their goal.
Therefore, the task at hand is rather straightforward. This prospective investor needs to find quality dividend paying stocks that they expect will increase their dividend every year by at least 10%. Thanks to their awareness and understanding of yield on cost, they do not need to try and reach for a higher and therefore potentially more risky yield in order to have the income they need available when they need it. This is just one example of how yield on cost can be a valuable and important investment metric for investors to consider. Of course, a lot has to do with the market environment they find themselves in at the time they are making these valuations.
I am not either for or against the concept “yield on cost.” To me it is just another tool in my investing tool chest that I can utilize to evaluate potential investing decisions I may be contemplating. Furthermore, I never think of it in isolation. Before making any buy, sell or hold investing decisions I always analyze and evaluate numerous investing metrics in order to determine whether or not the investments I am considering are sound and prudent at the time.
And, although I routinely look at and evaluate yield on cost, I never call it that. Instead, I think of it as “growth yield” which is the potential velocity of growth with which I believe the dividend component of a dividend paying stock can achieve. Although I am a major proponent and supporter of dividend growth investing, I also believe in always considering total return and I believe in doing my best to ascertain the amount of risk I need to take to achieve it. One of the things I appreciate most about dividend paying stocks is that I am simultaneously receiving a return of my capital as well as a return on it.
Finally, I would like to thank David Crosetti for the inspiration to write this article. I do agree with his thesis that current yield can be a more important measurement than yield on cost for the investor looking for and in need of maximum income from their portfolio. However, there are many other ways that the concept “yield on cost” can be looked at and utilized to assist investors with different objectives in making the proper investing decisions.
Disclosure: Long PG & MCD at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am long MCD, PG.
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