No less a figure than Albert Einstein once remarked that compound interest is the eighth wonder of the world, and that those who don’t understand it, pay it – and those that do, earn it.
Given this illustrious vote of approval, it might well be worth investigating whether this belief holds true or not. We explore what exactly compound interest is, how it applies to dividend investing, and what practical steps you can take to make a dividend reinvestment strategy work for you and your portfolio.
Compound Interest: The Most Powerful Force In The World?
Compound interest is actually a fairly straightforward concept to understand. In its most basic form, compound interest is just the interest you receive from some other interest you’ve already previously earned.
Crucially, compound interest differs from what is known as “simple interest” i.e. the interest you receive just from the principal amount of some investment or other kind of deposit.
But don’t be fooled!
The distinction between compound and simple interest has huge ramifications for the long-term profits you receive on your investments. Simple interest limits your earnings to just the same, small annual returns every year, whereas compound interest has the potential to deliver massive rewards over time.
Simple Interest vs Compound Interest Example
To give you an example of just how big this difference is, let’s consider what happens to two hypothetical investments, each starting with a principal of $10,000, and each generating 5% interest annually – but one under simple interest, and one under compound.
So, after 5 years, there’s not much difference: the simple interest investment is worth $12,500, while the compound interest investment is worth $12,763.
Fast forward to the 10 year mark, and the picture is pretty similar: the simple interest investment is now worth $15,000, while the compound interest investment has returned $16,289.
However, if we go 40 years ahead, there’s now a very significant difference: on a simple interest basis, the investment has only yielded a total of $30,000, while the compounded investment has more than doubled this with $70,400.
As you can see, simple interest accrues linearly, whereas compound interest grows at an exponential rate – and that’s a really important difference, as evidenced by the disparity between the respective investments’ total worth.
Dividend Compounding: Real World Examples
To see how compound interest and dividend investing can combine to staggering effect, we need look no further than one of Wall Street’s finest money men, Warren Buffett. The Oracle of Omaha has always understood the power of compounding, and he puts this to lethal use in his own dividend income-producing efforts.
In fact, the Berkshire Hathaway CEO currently owns a number of stocks that are generating upwards of a +20% dividend yield relative to cost basis. Indeed, one company – Coca-Cola – is actually giving Buffett a 54.2% annual yield, with its present dividend being worth $1.76, and the cost basis of the stock working out at just $3.2475 per share.
Other lucrative investments for Berkshire have been the payments processing company American Express, and the credit-ratings agency Moody’s, which have brought in annual yields, relative to cost basis, of 20.3% and 27.9% respectively.
The Moody’s play is really interesting because the firm’s yield right now is particularly low at only 0.86%. However, because Buffett got the stock so cheap compared to its current price of $326 – his cost basis for the company was around $10.05 per share – the $2.80 annual dividend turns out to be pretty hefty.
It also helps that Moody’s upped its dividend by 600% these last 12 years as well.
Source: Unsplash
It’s Not All About The Yield
Now that we’ve seen the power of compounding in action, it’s time to turn our attention to what kinds of stock are best suited for dividend investing.
To begin with, most dividends are described using their percentage yield as a common yardstick. Naturally, a larger starting yield will compound at a faster rate than a smaller one, and therefore you might be more inclined to look for stocks that maximize this key metric. However, yields are not static measurements, and can – and usually do – vary over time.
Furthermore, it’s not always companies with the highest yields that make for the best investment when it comes to dividend compounding either.
In fact, contrary to popular opinion, high yields can actually be a warning sign of a failing company – a firm’s yield might only be rising because its share price is falling, which is usually indicative of a poorly performing business. And if a dividend’s going to compound, it certainly needs to be paid over the long-term – which won’t happen if the company falls into dire straits.
Pay Attention To Payout Ratio vs Yield
Because of this, dividend investors will also look to other traditional indicators of financial health, especially a metric known as the dividend “payout ratio“.
This ratio tells us how well a company is able to cover its dividend obligations, and how likely it is to continue those payments in the future. The number is derived as a percentage of a company’s net income that’s used to fund its dividend payments.
While the size of an individual dividend payout varies between industries – REITs, for instance, are by law obligated to return 90% of their profits to shareholders – a dividend payout ratio of anything less than 50% is usually considered safe.
And even if a dividend yield seems fairly low at the present time, that doesn’t mean it will stay that way: many fast growing companies don’t see large earnings in the early stages of their life cycle, but can improve as they become more mature.
This means that what was once a low yielding dividend to begin with, can grow as the supporting business itself grows. There’s also a double-whammy effect here too, as better earnings usually lead to share price appreciation – meaning you get both capital growth and a compounding dividend return in one.
Conclusion: Does Dividend Investing Work?
Combining dividend investing with the power of compound interest is a surefire way to generate money – but choosing the right stocks to invest in is also important.
Following Warren Buffett’s cue might be one route to take in going about making your own stock picks. But even if you don’t settle on a business like Coca-Cola – which has increased its dividend payout for 60 consecutive years now – if you do stick with it for the long-haul, you’re almost certainly guaranteed to turn a profit.
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