Speaking Mathanese: Cost Basis

Welcome back to another edition of "Speaking Mathanese," our Motley Fool series that tackles financial math myths and deconstructs the computations that make the biggest difference to your bottom line.

This week, our quest to make you smarter than a fifth-grader has us enjoying a comforting cup of cost basis to ease the pain of the confounding confines of the compound annual growth rate.

Say that 10 times fast. Go ahead, I dare you.

The myth
What? You'd rather have this week's lesson instead? Fine. Here's our opening question:

My question relates to ... calculating total return for dividend-paying stocks. I understand that topic insofar as paying cash, but I would love to see an easy way to calculate the returns if the dividends are reinvested in additional shares every time they're paid.

Good question. Answering it requires that we return to the topic of cost basis. You can't calculate your total return till you know what belongs, and what doesn't belong, in your cost basis.

I know what you're thinking. "I bought Crocodile Dundee Dingo Sausage (TICKER: WOOF) for $10 a share and now it sells for $15 a share. My cost basis is $10!"

The math
Not if ol' Mick is like IBM (NYSE: IBM  ) , Nokia (NYSE: NOK  ) , and Coca-Cola (NYSE: KO  ) and pays a dividend. Here's how our friends at Investopedia define cost basis:

The original value of an asset for tax purposes (usually the purchase price), adjusted for stock splits, dividends, and return of capital distributions. This value is used to determine the capital gain, which is equal to the difference between the asset's cost basis and the current market value. [Emphasis mine.]

Still confused? No problem. Let's say you bought 1,000 shares for $10. Let's also say that you've received $350 in dividends that you've since reinvested in new shares. Your cost basis is $10,350.

Or, in mathanese:

Original purchase price + dividends 

You might be wondering why we don't look at cost basis per share. Some do. I don't, because I believe it adds unnecessary complexity to a simple equation.

For mutual funds, you also have to account for those year-end capital gains distributions you have reinvested into additional shares. So the mathanese becomes:

Original purchase price + dividends + capital gains distributions

Questions? Submit them here. And be sure to tune in next week when we get into why it's important to know your cost basis cold.

For more money ideas, get 30 days of free access to Motley Fool Green Light  right now. There's no obligation to subscribe.

Fool contributor Tim Beyers writes weekly about personal finance and investing basics. Have a Foolish money tip? Tell him. Tim owned shares of IBM and Nokia at the time of publication. Tim's portfolio holdings can be found at his Fool profile. His thoughts on personal finance, Foolishness, and investing in general may be found in his blog. Coca-Cola is an Inside Value pick. The Motley Fool's disclosure policy is lobbying its local school district for a course in beginning mathanese.

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