Yield on Cost vs. Yield on Price? It’s Opportunity Cost that Counts.

I read an interesting article on the Globe and Mail recently, about the “Yield on Cost Myth” (Archived copy may be found at this link). In a nutshell, the author argues that it is erroneous for an investor to consider the yield on cost when they are looking at the dividend yield for a stock; and as a dividend investor this is a very important topic for me. When you are looking at the cash flow stream from an investment, do you look at it from the perspective of what you paid for the stock, or what you would pay today for a stock?

First, some definitions. Yield on Cost is exactly what it sounds like: the total yield returned based on the original cost of the investment. Mathematically:

Yield On Cost=\frac{Dividend}{Average Cost Basis}

This compares to Yield on Price, or what typically we refer to as the normal “dividend yield” of a stock. This is simply the yield based on the current cost of the investment. Mathematically:

Yield On Price=\frac{Dividend}{Current Price}

Now, I do agree that one should focus on the Yield on Price of a stock, not the Yield on Cost of a stock. The reason for this is opportunity cost. Let’s consider the example cited in the original article:

  • You purchased BCE at an average cost of $30.00/share.
  • BCE’s current price is $62.95/share.
  • BCE’s current dividend is $2.73/share.
  • Shaw’s current price is $26.50/share.
  • Shaw’s current dividend is $1.19/share.

Summarizing all of that, let’s do the comparison of the different yields:

 

Company ACB ($) Price ($) Dividend ($) Yield on Cost Yield on Price
BCE 30 62.95 2.73 9.10% 4.34%
Shaw n/a 26.5 1.19 n/a 4.49%

The ACB and Yield on Cost for Shaw are n/a because we don’t actually own them yet. As pointed out in the article, at first glance it makes perfect sense to sell your shares of BCE, and purchase the shares of Shaw, and reap the additional 0.15% yield (which equates to a 3.55% relative gain between yields, since 4.49% is 3.55% greater than 4.34%).

The challenge with this is that it assumes that we live in a frictionless environment. By swapping your BCE shares, you’ll be victim to all at least two, and possibly three, types of friction that I mentioned in one of my earlier posts. Unless you are in a tax-deferred (e.g. RRSP) or tax-free (i.e. TFSA) account, you will be subjected to capital gains tax on the sale of the BCE shares. In addition to this, you will be hit with one, possibly two, commission charges by selling the BCE, and purchasing the Shaw.

However, the biggest challenge is with rounding friction. This is illustrated by the below table, which illustrates the net change in your cash flow stream, based on holding 10, 100, and 1000 shares of BCE:

Activity Scenario 1 Scenario 2 Scenario 3 Scenario 4 Notes
Number of BCE Shares 1 10 100 1000 What you started off with
BCE Share Price $62.95 $62.95 $62.95 $62.95
Shaw Share Price $26.50 $26.50 $26.50 $26.50
Commissions $9.95 $9.95 $9.95 Per trade commission
Proceeds of Selling BCE Shares $62.95 $619.55 $6285.05 $62940.05
Shaw shares purchased 2.38 23 236 2374 Number of shares you can purchase from the BCE proceeds
BCE dividend $2.73 $27.30 $273.00 $2730.00 Net dividend pre-swap
Shaw dividend $2.83 $27.37 $280.84 $2825.06 Net dividend post-swap
Delta $ $0.10 $0.07 $7.84 $95.06
Delta % 3.55% 0.26% 2.87% 3.48%
Implied Delta % 3.55% 3.55% 3.55% 3.55% The relative difference between the Shaw yield and the BCE yield.
Delta Variance (3.29%) (0.67%) (0.06%) How much over or under we are in our real gain in yields, relative to the base case.

Looking at this, you can see that the difference in yield is not necessarily as clear-cut as one would think. Scenario 1 represents the base case in a frictionless environment, and from there we can see that the implied delta, and the actual delta, are equal. However, once we get into the real world (e.g. rounding, commissions), this quickly changes. Looking at 10, 100, and 1000, shares, the actual gain varies. You do come out ahead, but not by as much as the frictionless scenario. Moreover, this example assumes no taxes! When we introduce taxes, things get even worse, illustrated below:

Activity Scenario 1 Scenario 2 Scenario 3 Scenario 4 Notes
Number of BCE Shares 1 10 100 1000 What you started off with
BCE Share Price $62.95 $62.95 $62.95 $62.95
Shaw Share Price $26.50 $26.50 $26.50 $26.50
Commissions $9.95 $9.95 $9.95 Per trade commission
Proceeds of Selling BCE Shares $62.95 $619.55 $6285.05 $62940.05
Tax Rate 16.95% 16.95% 16.95% 2016 Ontario Tax rate for $83M-$86M income tax bracket, from taxtips.ca
Available proceeds to purchase Shaw shares $62.95 $514.54 $5219.73 $52271.71
Shaw shares purchased 2.38 19 196 1972 Number of shares you can purchase from the BCE proceeds
BCE dividend $2.73 $27.30 $273.00 $2730.00 Net dividend pre-swap
Shaw dividend $2.83 $22.61 $233.24 $2346.68 Net dividend post-swap
Delta $ $0.10 ($4.69) ($39.76) ($383.32)
Delta % 3.55% (17.18%) (14.56%) (14.04%)
Implied Delta % 3.55% 3.55% 3.55% 3.55% The relative difference between the Shaw yield and the BCE yield.
Delta Variance (20.73%) (18.11%) (17.59%) How much over or under we are in our real gain in yields, relative to the base case.

Again, with Scenario 1 as our base case (no taxes, no commissions, no rounding), we see that our net gain is exactly 3.55%, which is what we would expect. However, the net result looks gloomier with 10, 100, or 1000, shares: our total income is less after we have made the swap!

At the end of the day, while yield is important, and understanding the difference between Yield on Cost and Yield on Price is important, it is opportunity cost which is the most important. Even though BCE’s Yield on Price was lower than Shaw’s Yield on Price, the cost to make the switch effectively cost us 14% in annualized net income!



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