Dividend yield is one of the most commonly utilized financial ratios for income investors. It is also one of the easiest to calculate. The current dividend yield is simply the annual dividend payment of a stock divided by the share price. It tells an investor the amount of dividend income they will receive from buying a stock, expressed as a percentage.

For example, PepsiCo (PEP) has a current dividend yield of 3.4%. But income investors should also familiarize themselves with yield on cost, which is different than the current dividend yield. While the current dividend yield is simply the company’s dividend per share divided by the current share price, yield on cost is the current dividend per share divided by the investor’s cost basis.

Yield on cost basically shows the yield of the stock from a historical basis, considering the original price paid and not the current price. It also proves the benefits of investing in high-quality dividend growth stocks like PepsiCo.

Why Yield On Cost Is Important

The current yield is a very simple equation. In PepsiCo’s case, the company currently pays an annualized dividend of $3.71 per share. With a recent share price of $108, investors buying the stock today will earn a dividend yield of 3.4%. The current dividend yield could change going forward, if the share price fluctuates, or if the company adjusts its dividend payment higher or lower. Dividend stocks are attractive for income investors, as they provide dividend income, which is especially valuable in a low interest rate environment.

Put simply, dividend stocks are good—but dividend growth stocks are even better. Companies that reward shareholders with a dividend demonstrate that they prioritize the interests of their investors. At the same time, companies that can raise their dividends on a regular basis prove that they have strong business models with durable competitive advantages. There is perhaps no stronger sign of a high-quality business than consistent dividend increases each year.

PepsiCo is a Dividend Aristocrat, an exclusive group of 53 stocks in the S&P 500 Index that have raised their dividends for 25+ consecutive years. PepsiCo has actually raised its dividend for over 40 years in a row, including a solid 15% increase in 2018. Continued dividend growth over many years leads to a high yield on cost. To calculate yield on cost, divide the current dividend per share by the cost basis per share. Then, multiply by 100 to derive a percentage.

Yield on cost can be influenced by many factors. The yield on cost could be higher than the current yield if an investor purchased shares at a lower price. Or, yield on cost could be higher if an investor reinvested the dividends over the holding period. Reinvesting dividends allows investors to use their dividend payments to buy additional shares of stock. This results in more dividends, which in turn allows for more shares to be purchased, and so on. Another way yield on cost can rise over time is by selecting stocks that raise their dividends over time. Dividend growth stocks reward their shareholders who buy and hold for the long-term with higher dividend income each year. PepsiCo is a great example of a dividend growth stock.

How To Earn 10% A Year From PepsiCo

For example, assume that PepsiCo raises its dividend by 8% per year over the next 10 years. This is a reasonable dividend growth estimate for PepsiCo, as the company has averaged 8.1% annual dividend growth in the past 10 years. If the company maintains an 8% annual dividend growth rate, in 10 years the annualized dividend payment will rise to approximately $8.01 per share. The investors who purchased shares today at the same price of $108, will therefore have a yield on cost of 7.4%.

Now assume that same investor reinvested their dividends along the way. This would have the effect of raising the dividend growth rate by the amount of the current dividend yield, which in this case is the reinvestment rate. In other words, an investor who buys PepsiCo shares at a current yield of 3.4% and reinvests dividends, will have total dividend growth of 11.4% per year, assuming the company raises its dividend by 8% each year and the current yield stays at 3.4%. With an 11.4% total dividend growth rate, the investor buying today at $108 per share will generate a yield on cost of 10.0% in 10 years.

When forecasting future dividend growth rate, it is important to use reasonable estimates. Not all companies can maintain a high dividend growth rate over time. It takes a profitable business with strong brands, competitive advantages, and growth opportunities. PepsiCo has all of these qualities. It is a diversified food and beverage giant, with annual revenue of $63 billion and a market capitalization of $153 billion.

PepsiCo has a large portfolio of food and beverage brands. Food accounted for approximately 53% of sales in 2017, with beverages the remaining 47%. It has a diversified portfolio, with 22 individual brands that each bring in at least $1 billion in sales each year. In addition to its core beverage brands like Pepsi, it has a huge snacks portfolio under the Frito-Lay brand, which is a major driver of PepsiCo’s growth.

Source: 2018 CAGNY Conference Presentation, page 4

These brands provide PepsiCo the growth necessary to raise its dividend each year. For example, the company grew organic revenue by 4.9% in the most recent quarter, and by 3.4% over the first three quarters of 2018. Adjusted earnings-per-share increased 6% over the first three quarters.

In recent years, PepsiCo has built a large portfolio of healthier food brands like Quaker, Naked, and Sabra. It is investing in healthier products to adapt to changing consumer preferences, in particular the decline in soda consumption. In late August, PepsiCo announced it will acquire at-home carbonated beverage maker SodaStream Ltd. (SODA) for $3.2 billion. This acquisition will help PepsiCo move further into the at-home sparkling beverage market.

PepsiCo expects to generate adjusted earnings-per-share of $5.65 in 2018, an 8% increase from the previous year. With a current annual dividend of $3.71 per share, PepsiCo is likely to have a dividend payout ratio of 66% for 2018. This means the current dividend payment is sufficiently covered, with room for continued increases each year.

Final Thoughts

With so many various financial ratios and statistics out there, investing in stocks can seem overwhelming. But when it comes to dividend stocks, yield on cost is one of the most important concepts an investor should understand, as it reveals the true power of compounding dividends over time. Investing in a stock for a 3.4% dividend yield today might not seem overly impressive, but put differently, a high-quality dividend growth stock like PepsiCo could provide a 10% yield on cost in 10 years through reinvested dividends and dividend growth.