Yield on cost is a somewhat popular metric among investors who focus on dividends and income. It's a measure that compares the dividend yield of an investment to the investor's original cost basis for the position. It's an interesting way to look at long-held stocks that have both appreciated in price and raised their dividends over time.

For those who use it, the metric can provide a sense of accomplishment, much like looking down the side of a mountain does for a climber that has scaled the summit. The only real problem with the metric, however, is that it's absolutely useless from an analytic perspective.

Why it's so bad
The biggest issue with yield on cost is that it's often used to look backward at the tremendous run that an investor has had with a long-held, extremely successful investment. If you manage to hold onto the stock of a successful company for 30 years and watch it grow and raise its dividends over time, that number can reach spectacular levels, indeed.

Yet no matter how good the number looks in hindsight, on its own, yield on cost doesn't really help you figure out what to do with your money right now. Much like with Harry Potter's Mirror of Erised, it's far too easy to get tricked into staring into an unrepeatable, historic eternity instead of focusing on the future of the companies you own. As an investor, you need to focus on the future and make forward-looking decisions based on current reality, not past glory.

How you can profit from it anyway
In spite of its shortcomings, yield on cost can help you invest better, if you use it correctly. If you flip it on its head and use it to project forward instead of look backward, you can search for companies with a decent chance of getting you a large yield on cost some time in the future.

To get to a high yield on cost in spite of a stock's relatively low current dividend yield, two things generally have to happen:

  1. The stock has to rise after you buy it.
  2. The company has to increase its dividend.

Both those are good "problems" to have, and your challenge as an investor is to seek out stocks that have the potential to do that for you -- repeatedly. In other words, getting to the point where you have a high yield on cost is generally a good thing, even if holding on to the stocks that got you there may not always be the best move for your future.

Across industries, companies with the potential to get you to that point of a high yield on cost are ones that:

  • Use debt only sparingly, as evidenced by a debt to equity ratio below two.
  • Back up their dividends and earnings with solid, positive cash from operations.
  • Have established a pattern of paying and raising their dividends.

Take a look, for instance, at these companies and their current yields on cost had they been bought 30 years ago:

Company

Current Dividend

Closing Price on April 16, 1981 (split adjusted)

30 Year Yield on Cost

Cash from Operations (in millions)

Debt-to-Equity Ratio

Coca-Cola (NYSE: KO) $1.88 $1.48 127.1% $9,532 0.75
Lowe's (NYSE: LOW) $0.44 $0.33 133.5% $3,852 0.36
Becton Dickinson (NYSE: BDX) $1.64 $3.06 53.6% $1,816 0.56
Chubb (NYSE: CB) $1.56 $2.42 64.5% $2,352 0.26
Sigma-Aldrich (Nasdaq: SIAL) $0.72 $1.21 59.3% $523 0.27

Source: Capital IQ, BigCharts, and Yahoo! Finance.

In spite of their fairly diverse industry backgrounds, they do have a few factors binding them together: They all have modest debt-to-equity ratios, solid cash flows, and more than 30 years ago, they had all already begun paying and raising their dividends.

Look toward the future
One way to eventually get to that high yield on cost is to look for companies that have the potential but are not quite as far down the path of getting you there. Generic-drug maker Teva Pharmaceuticals (Nasdaq: TEVA), for instance, has a fairly healthy balance sheet, solid operating cash flows, and is establishing a decent dividend reputation, as well.

From a less well-established, but still potentially long-term lucrative perspective, technology networking giant Cisco Systems (Nasdaq: CSCO) recently authorized its first cash dividend. Its potential for long-term sustained dividend growth has already been described as legendary. Only time will tell whether Cisco lives up to the hype and hope, but now that it has finally started putting its money where its mouth is, it has decent odds of succeeding.

Ultimately, looking backward at your yield on cost doesn't help you make good decisions with your existing investments. But looking forward at what your yield on cost might become -- and what it takes for a company to get there -- can assist you in picking investments that can help you earn those future bragging rights.

At the time of publication, Fool contributor Chuck Saletta owned shares of Lowe's. Becton Dickinson, Coca-Cola, and Lowe's are Motley Fool Inside Value choices. Coca-Cola is a Motley Fool Income Investor pick. Motley Fool Options has recommended writing covered calls on Lowe's. Teva Pharmaceutical is a Motley Fool Global Gains selection. Alpha Newsletter Account, LLC owns shares of Cisco Systems. The Motley Fool owns shares of Coca-Cola and Teva Pharmaceutical and has created a bull call spread position on Cisco Systems. 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.