The Magic of Compounding Interest
Compounding is such a powerful force that it has made very modest investors ridiculously wealthy. I know of stories of Coca-Cola investors who bought shares in the stock many years ago, did nothing with it and are now millionaires with a very steady stream of income from the growing dividends. Want more proof than just what I have heard? Consider the following chart that was provided on the Motley Fool by author Dan Caplinger:
As you can see, the impact of reinvesting dividends over a 30 year period can lead to almost 3 times as much in ending value than not reinvesting dividends. How does this happen? Compounding dividend returns.
Compounding Dividends Defined
Compounding, in the context of dividends, is defined by the following phrase: Generating dividends from previous dividends, on an ongoing basis. In other words, we receive dividends from the dividends we received earlier over and over again. Still confused? Let’s look at an example I quickly drew up in Apple Numbers:
Pretty powerful effect – our original 100 shares becomes over 142 shares over a 20 year period, simply from the dividends we plowed back into the stock. No additional money was added and we just let the stock do its work.
As powerful as this example is, there is an even more impactful example that I can provide…
Compounding Dividends with Dividend Growth
In this example, I want to show what happens when the stock we own increases its dividend every year, which many stocks we would consider at Dividend Stocks Rock have done. Consider this example:
Our original 100 has now become 177 shares over the same 20 year period! That from a pretty common 5% dividend increase every year. Now it is important to note that dividend increases don’t always grow at the same amount every year, but for simplification purposes I kept it consistent. The message is still the same: dividend growth with compounding can really help our portfolios grow over time.
Coca-Cola (KO) – A Real Life Example
Theoretical examples with lengthy Excel spreadsheets are interesting, but there is nothing like a real life example to understand the true power of compounding dividend growth. Take Coca-Cola (KO) for example. I’ve made some research about its dividend yield history. The furthest I could get was 1987. From 1987 to 2013, the average yield paid by KO is 1.94%. If I take the last ten years, the dividend yield is a bit better with an average of 2.58%. Still, this stock, by filtering only with dividend yield, will fly under your radar 9 times out of 10.
However, the company is very keen on increasing its dividend. Therefore, it has doubled its dividend every 6-7 years for the past 50 years. So if you bought the stock 21 years ago, your dividend on your original investment is more likely to look like 9% than 2.90%. So imagine that 21 years ago, you had $300,000 to invest. Today, this $300,000 would pay $27,000 in dividend instead of $8,700 if you were to invest it today. All right, we need to compound inflation, $300K 21 years ago is now worth $478,686. Therefore, a similar investment would pay $13,881 in today’s dollar ($478,686 * 2.90%) as compared to $27,000 if you had invested the “same amount of money” 21 years earlier.
This is how an investor who would have bought a share of KO back in 1987 would have received over $11 dollars in dividends over the following 26 years. Did I mention that this investor would have purchased his only share of KO for roughly $2.50?
As you can see, compounding is one of the most dominant forces available to individual investors. With enough time, it can turn our small portfolios into something very overwhelming. Couple your run of the mill compounding with the impacts of dividend growth and you have a tool that you can use to really add growth to your portfolio.