Monday, December 22, 2014

What's More Powerful Than Compound Interest?

Simple interest is where interest is calculated on the original principal amount and unpaid interest is not added to the principal for future calculations. Compound interest is what occurs when interest previously earned and is unpaid is added to the principle and is considered when calculating future interest - i.e. earning interest on interest. This is an extraordinarily powerful wealth building tool.

Albert Einstein is attributed as the author of the following quotes:
Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.

Compound interest is the most powerful force in the universe.

Compound interest is the greatest mathematical discovery of all time.
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 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. Let's revisit 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 growth 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%).

We would all like to find a good dividend growth stock the yields 5% and grows 10% per year. Those are hard to come by these days. However, you might want to consider these dividend growth stocks with a dividend growth greater than 7%, a yield greater than 2.75% and has grown dividends for 25 or more consecutive years:

The Coca-Cola Company (KO) is the world's largest soft drink company, KO also has a sizable fruit juice business. The company has paid a cash dividend to shareholders every year since 1893 and has increased its dividend payments for 52 consecutive years.
Yield: 2.9% | Dividend Growth: 8.1%

Erie Indemnity Co. (ERIE) is a management services company that provides sales, underwriting, and policy issuance services to the policyholders of Erie Insurance Exchange in the United States. The company has paid a cash dividend to shareholders every year since 1991 and has increased its dividend payments for 25 consecutive years.
Yield: 3.0% | Dividend Growth: 7.2%

Abbvie Inc. (ABBV) is a global research-based pharmaceuticals business that emerged as a separate entity following its spin-off from Abbott Laboratories at the start of 2013. AbbVie's key drug is Humira for rheumatoid arthritis. The company has paid a cash dividend to shareholders every year since 1926 and has increased its dividend payments for 42 consecutive years (including the years ABBV was part of ABT).
Yield: 2.9% | Dividend Growth: 10.1%

Exxon Mobil Corp. (XOM), formed through the merger of Exxon and Mobil in late 1999, is the world's largest publicly owned integrated oil company. The company has paid a cash dividend to shareholders every year since 1882 and has increased its dividend payments for 32 consecutive years. See full analysis here.
Yield: 3.1% | Dividend Growth: 9.6%

Chevron Corporation (CVX)  is a global integrated oil company (formerly ChevronTexaco) has interests in exploration, production, refining and marketing, and petrochemicals. The company has paid a cash dividend to shareholders every year since 1912 and has increased its dividend payments for 27 consecutive years.
Yield: 4.1% | Dividend Growth: 7.9%

If Einstein thought compound interest was the most powerful force in the universe, he would be blown away with compound dividends, relatively speaking. Dividend compounding, it doesn't get much better than that!

Full Disclosure: Long KO, ERIE, ABBV, XOM, CVX, in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.

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