Wednesday, March 9, 2016

3 Powerful Concepts for Compounding Wealth with Dividend Stocks

It is the goal of many people to build enough wealth to put their kids through college, payoff their mortgage, be in a position to help their family and enjoy a financially worry-free retirement. Most people simply don't earn enough to accomplish all these goals without a little help.

If you don't have a generous relative or wealthy parents, you will need to devise a plan to help you reach your goals. Here's how I plan to do it with three very powerful concepts...

The Concept of Compounding

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.

With a constant interest rate your earnings spiral up each and every year when you reinvest the interest. 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.

Once I grasped this concept as a child, it forever changed the way I looked at money. Cash was no longer measured in terms of what it could buy me today, but what is its long-term growth potential.

But there is something even more powerful than compound interest. Unfortunately, something I didn't discover until I was much older.

The Concept of Compound Dividends

Compound dividends are like compound interest on steroids! Let’s continue the above example and assume that instead of depositing money in an interest-bearing account, you instead purchase good dividend growth 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, $6.70 in year 3, $7.82 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 $34.47 from the dividend stock. That is more than a 35% increase!

As good as this is, it still gets better!

The Concept of Appreciating Dividend Stocks

Good dividend stocks’ yields tends to stay within a given range. Thus, 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 Growth Stocks To Consider

A dividend growth rate of 7.2% means your dividend income will double every 10 years - with no reinvestment of dividends.

Below are several stocks with a dividend growth rate in excess of 7.2%:

Abbott Laboratories (ABT) is a diversified health care products company that is now focused on nutritionals, diagnostics, generic drugs, and medical devices, following the spinoff of its R&D-based prescription pharmaceuticals business.
Yield: 2.7% | Growth: 8.3%

Bunge Limited (BG) is a large, geographically diverse agribusiness and food company.
Yield: 2.8% | Growth: 9.7%

3M Co. (MMM) provides enhanced product functionality in electronics, health care, industrial, consumer, office, telecommunications, safety & security and other markets via coatings, sealants, adhesives and other chemical additives.
Yield: 2.8% | Growth: 7.3%

PepsiCo, Inc. (PEP) is a major international producer of branded beverage and snack food products.
Yield: 2.8% | Growth: 7.5%

T. Rowe Price Group Inc. (TROW) operates one of the largest no-load mutual fund and life cycle fund complexes in the United States, with December 31 AUM of nearly $773 billion.
Yield: 3.0% | Growth: 12.8%

Raven Industries Inc. (RAVN) is an industrial manufacturer that provides electronic precision-agriculture products, reinforced plastic sheeting, electronics manufacturing services, specialty aeronautics, and sewn products.
Yield: 3.2% | Growth: 8.3%

Even if I had a generous relative or wealthy parents (which I don't), I wouldn't want to trust my financial future to what they might or might not do. Especially not when I can take charge of my own future utilizing the concepts above. Dividend compounding, it doesn’t get much better than that!

Full Disclosure: Long MMM, PEP in my Dividend growth portfolio and long TROW, RAVN in my High Dividend Growth Portfolio. See a list of all my Dividend Growth Portfolio Holdings here.

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