Compound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest - i.e. earning interest on interest. I remember the elation as a small child when I first grasped the concept of compound interest (ok, so I lived a deprived childhood, but it has been financially rewarding). With a constant interest rate your earnings spiral up each and every year. Consider a $100 deposit earning 5%, compounded annually. In the first year you will earn $5, $5.25 in year 2, $5.51 in year 3, $5.79 in year 4, $6.08 in year 5, and so on.
So, back to the title question. What's more powerful than compound interest, faster than an tax audit and able to leap a 1099* in a single bound? Compound Dividends!
Compound dividends are like compound interest on steroids, simile speaking, of course. Let's continue the above example and assume that instead of depositing money in an interest-bearing account, you instead purchase good dividend stock with a current yield of 5%. So, in the first year you will earn $5. Which is the same as the 5% interest-bearing account, but that is where the similarities end. Good dividend stocks increase their dividends each year. In this example, let's assume a 10% dividend growth rate. So you will earn $5.78 in year 2, $6.71 in year 3, $7.81 in year 4, $9.17 in year 5, and so on.
Comparing the above two scenarios over the 5-year period, you will earn $27.63 from the interest-bearing account as compared to $37.47 from the dividend stock. That is more than a 35% increase!
Can life get any better than this? Yes it can! Good dividend stocks' yield tends to stay within a given range, so if dividends are increasing each year, the only way to keep a consistent yield is for the price of the stock to go up. In order to have a 5% yield in our above example at the end of year 5, the stock would have to be worth $183.44 (9.17/183.44 = 5%).
Dividend compounding, it doesn't get much better than that!
* A 1099 is the U.S. tax form used to report non-wage income from things such as interest, dividends and miscellaneous earnings.
Popular Posts - Last 7 days
I know very little about hockey, but I have always loved this quote: I skate to where the puck is going to be, not where it has been. &quo...
Linked here is a detailed quantitative analysis of Omega Healthcare Investors, Inc. (OHI). Below are some highlights from the above linked ...
Linked here is a detailed quantitative analysis of United Technologies Corp. (UTX). Below are some highlights from the above linked analysi...
Any income investor will tell you that it is important for a company to sustain its dividend . However, as an investor in dividend growth st...
Each Sunday I highlight any notable articles that I came across over the past week. Though I may not always agree with each of the articles ...
Presented below are are my Dividend Growth Stocks portfolio holdings. This is not a recommendation to buy these securities. I have classifi...
Like many that came before me, I am on a journey to construct a portfolio that will provide me... Dividends 4 Life
The Fable of Two Mules Once there were two heavily-laden mules making a long journey together. One was carrying a load of salt and the othe...
Monday, October 31, 2011 will mark my fourth full year of writing as Dividends4Life . It is hard to believe another year has passed. Like th...
Has someone near and dear to you responded with a 'I was only trying to help' after royally messing something up? Have you ever tink...