Investing 101: Effective Yield
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In investing it's dangerous to assume everyone knows what you are talking about. I've used the term effective yield in several posts, and realized maybe there are some that don't really understand this concept. Here is a quick crash course on why effective yield is so important.
Effective yield just means if you bought a stock before today, when you collect your dividends you are not getting the same yield that someone buying the stock today is receiving. The longer you hold certain stocks, you are actually collecting a much higher yield. This is critically important in knowing what to do with stocks you have held for a while. It's easiest to understand this concept by seeing it, so we'll use Procter & Gamble (NYSE: PG) as an example. The company has a long history (54 years) of raising its dividend. When it comes to effective yield this type of company is where the concept is so important to understand. Here is what I mean:
Procter & Gamble current price: $65.12
$2.10 current annual dividend (current yield 3.22%)
Let's say that you bought Procter & Gamble 10 years ago. Through the worst of market timing, in 2002 you paid the highest price that year. Your purchase price would have been about $44.65. Now I know some people are immediately going to say, well if I bought at $44.65 and the stock is only at $65.12 that's only about a 4.6% return annually over the last 10 years. That's not a very good return for taking on risk in the stock market in the last 10 years. Let's look at the all important effective yield, and how it would have changed for you over the last 10 years.
As you can see, your effective yield increases every year. The reason is when you buy in at $44.65, that is the price that you divide the annual dividend into. So in 2011 you are dividing $44.65 by $2.10 = 4.70%. This means you're getting much better than the 3.22% yield that someone buying today is getting. These annual dividend yields, have to be added to any return from the stock going up to get your real return. So at the end of the 10 years your return is actually closer to 7.7% per year (4.6% from average price increase + 3.1% from average dividend return). In light of the last 10 years, that 7.7% average return looks pretty good to me. In addition, your return might have been much higher if you elected to reinvest dividends each quarter.
The bottom line is if you hold onto a stock that pays and increases dividends you're actually getting a better dividend than people who buy today. Keep this in mind the next time you are trying to decide if keeping a company like a Procter & Gamble in your portfolio makes sense. Here are a couple other companies that also have a long history of increasing their dividend each year.
Whether it's Procter & Gamble, Abbott, or 3M you can hardly go wrong picking a company with a long history of increasing its dividends. Each year you can expect your effective yield to get higher and higher. Remember effective yield the next time someone asks you why you would buy a boring dividend paying stock.
Motley Fool newsletter services recommend 3M Company and The Procter & Gamble Company. The Motley Fool owns shares of Abbott Laboratories. MHenage has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.