When approaching retirement, a common strategy is to convert a substantial portion of one’s investment portfolio to income producing securities, whether this be bonds, dividend paying stocks, or even something ultra-conservative such as CDs. If the intention is to live solely off of this income, the most obvious question is: What size must the portfolio be to sustain your desired lifestyle?

The S&P 500 index yields 2.12% at the time of this writing, although individual stocks within the index comprise the full range from those that don’t pay a dividend at all, to those in the double digits. But for argument sake, let’s say that you plan your retirement based on a 2.12% yield. With a $1 million portfolio, you will have an income of just over $21,000 per year – before tax! It’s possible to live off this amount (many people do) but it’s possible to do much better, particularly if implementing your investment strategy early.

Specifically I am going to look at how a Dividend Growth Investment strategy can turn that 2% dividend yield into a much more substantial *yield on cost*. For those new to these terms, dividend growth investing is a method whereby stocks are purchased of companies who have a history of increasing their dividend year after year – essentially the equivalent of an *annual raise* for those relying on dividends as their primary source of income.

Dividend yields are calculated by simply taking the company’s annual dividend and dividing it into the current share price. For example, if a company is currently trading at $100 / share and pays a $5.00 dividend annually, it’s current yield is 5% ($5 / $100). Yield on cost however is quite different. YoC is calculated by taking the current annual dividend and dividing into the average cost per share that you paid for the stock. YoC can be much higher than the current dividend yield if the company raises it’s dividend on a frequent basis.

Let’s look at an example using actual numbers. In 2003, Chevron (CVX) was trading at $43.50 and paid a $1.43 annual dividend. This works out to a yield of 3.29%. Let’s say you purchased 100 shares back then for a total investment of $4,350. CVX has increased it’s dividend every year since 2003 (actually for the past 25 years), and is now paying a $3.60 / share dividend. Assuming you haven’t bought any additional shares in the past 10 years, your total cost is still the same $4,350, or $43.50 / share. Therefore your yield on cost is much higher: $3.60 / $43.50 = **8.3%**

This is the power of starting investing in dividend growth stocks early, and I don’t often see this point emphasized enough. In addition to the stability that dividend growth stocks provide, the additional income arising from the higher yield on cost can be quite substantial.

Let’s look at one more example, this time assuming that $5,000 is invested in CVX every year for the past 10 years:

At the end of 10 years, we will have invested a total of $50,000 and will have purchased 701 shares. Our average cost per share is therefore $71.36 and based on the 2012 dividend of $3.51, our yield on cost was 4.92%, a whole 1.67% higher than the stock’s current yield. One or two percent may not sound like that much, but that’s actually over 50% higher than the 3.25% current yield!

I hope this helps to explain the power of one of the misunderstood aspects of dividend growth investing. Be sure to try out my free yield on cost spreadsheet to play around with the numbers yourself!