It’s one of the most important concepts in income investing — yet it doesn’t get addressed nearly enough.
Today, I want to change that. Because once you understand the power of this concept, it may change the way you think about dividends forever.
Calculating a security’s current yield isn’t hard. You take its total annual dividend payments, divide that by its current price and multiply by 100.Simple enough, right?
Let’s take a look at one of the long-time holdings in my premium newsletter, The Daily Paycheck, to see this in action.
Magellan Midstream Partners (NYSE: MMP) is a master limited partnership (MLP) that currently pays a quarterly dividend of $0.74 per unit.
Today, gas prices are 42% cheaper on average than they were a year ago. That means Americans are on pace to spend $100 billion less at the pump in 2015.
Now let’s do the math…
MMP’s Annual Dividend: 4 X $0.74 = $2.96
MMP’s Current Price: $69.68
MMP’s Current Yield: ($2.96/$69.68) = 4.2%
Now, I picked MMP as an example for a reason. It perfectly illustrates the point I want to make in today’s essay.
You see, some income investors turn their noses up at yields below 5%. As such, you might be tempted to look at MMP’s yield today and decide to search elsewhere.
But turning away a security like MMP just because the yield isn’t appealing today would be a huge mistake.
Remember: higher yielding securities usually come with higher risks. If you see a security yielding 7%, 8%, 10% or more… there’s often a reason for it.
There is a way, however, to get higher yields from lower-yielding, lower-risk securities. All you need is the right security and a little time.
For instance, right now I’m earning a 14.6% yield from MMP.
How is this possible? Let me show you…
Yield On Cost: A Fast-Growing Dividend’s Gift That Keeps On Giving
When I bought MMP back in February 2010 for The Daily Paycheck newsletter, its quarterly dividend was only $0.355 per unit. As you can see in the chart below, MMP has raised its dividend 108.5% since then.
So if you bought 100 units of MMP back when I did, you could expect to earn $1.42 per unit a year, or a total of $142 annually. Today, those same units are paying $2.96 per unit, or a total of $296 in income annually.
Back then, I was able to buy my MMP units for $20.32. So my yield — based on my original cost — is $2.96/$20.32 = 14.6%.
I’m not taking on any more risk than any other investor who is buying MMP today. But I am getting more than three times the yield they’re getting — based on the cost of my original investment.
Current yield is just a snapshot in time. It fluctuates every second of the trading day as the price of a security changes. But if you want your dividend income to grow as fast — or faster — than your expenses in retirement, you want a security that can grow its yield on cost over time. And to do that, you want to look for securities with a good track record for dividend growth.
I specifically bought MMP because it had a great reputation for raising its dividend. Since its IPO in 2001, MMP has raised its quarterly dividend 53 times, increasing its initial dividend rate by 464%.
When I’m researching a security with fast dividend growth to add to my Daily Paycheck portfolio, I look at more than the current yield. So should you. I don’t want to overlook the next security that could deliver a 108.5% increase in dividend income — just as MMP has done for me and my subscribers.
It’s a simple concept, but it gets lost on income investors all too often. And it’s the key to avoiding the sorts of high-yield traps most investors fall into and uncovering the best steady dividend growers on the market.
Chief Investment Strategist
The Daily Paycheck
Source: Street Authority