Compounding is one of the most powerful concepts in investing. Compounding occurs when your money grows at a geometric (exponential) rate rather than a linear rate.
[Compounding is especially interesting in dividend growth investing, because it happens at two levels.
- Companies compound their own value by reinvesting in themselves, thus growing their revenue, earnings, and dividends.
- Investors can reinvest the dividends they receive and compound them in their own portfolio. That adds a second layer of compounding to the one that occurs within the company.
This lesson is a primer on compounding and also addresses the first bullet point above. Lesson 5 will focus on the second bullet point.
Let’s talk about compounding in general. Compounding means earning money on money already earned.
Great companies compound money within their businesses. They earn money, then take some of the money already earned (“retained earnings”) and invest it back into the company to fuel growth.
Compounding is geometric.
That means that growth occurs not in a straight line, but in a line that curves upward, as shown in the cartoon above.
Each year’s growth differs from the prior year’s not by a constant amount, but by a constant rate.
When applied to dividends, this annual rate of increase is called the dividend growth rate (DGR).
The difference between straight-line growth and compound growth is startling. Do you remember the childhood brain-teaser about your father giving you a penny allowance on the first day of the month and then doubling the amount each day? Most kids think that’s nothing special.
But they’re wrong. If you double a penny for 30 straight days, the amount your father owes you on the 31st is more than $10 million dollars!
Let’s relate these principles to dividend growth investing with a simple hypothetical example.
Say that a successful company raises its dividend by 10% per year. In the first year, its dividend is $10.00 per share per year. Let’s see how it grows when it’s compounded by a DGR of 10% per year for 10 years. Look at the blue columns in the following table.
The table show how powerful compounding is. In 10 years, the dividend increases to almost 2.6 times the amount of the first year’s dividend.
At first, this might seem impossible. After all, each year’s increase was just 10%. If you add up 10 years’ worth of 10% increases, shouldn’t that give you a 100% total increase? Shouldn’t the amount after 10 years be 2.0 times the beginning amount?
No! The reason that the amount after 10 years is way more than twice as much is the result of compounding. Each year’s 10% increase was tacked onto the prior year’s amount. That means that each year’s increase is more – in dollars and cents – than the year before.
Compounding is like a snowball rolling down a hill: The bigger it gets, the faster it gets bigger.
You can see that each year’s increase is bigger in the table above. Look in the 3rd column, labeled “Dollar Amount of Increase.” Each year, the dollar amount of the increase is larger than the year before. So while the dividend growth rate stays constant at 10% per year, the dollar amount of each increase grows every year. That’s the power of compounding.
The intuitive doubling of the dividend amount – to 200% of the original – becomes 260% as a result of compounding. That is a 30% additional boost in dollars (260 / 200 = 30%).
For comparison, in the red column, we show the same dividend increasing by a constant amount of $1.00 per year. That represents straight-line growth. It matches the intuitive result of 100% total increase. In the 10th year, you receive twice the amount as in the first year.
By the end of the 10 years shown in the table, the annual dividend with compounded growth has far surpassed the dividend being raised by a constant amount each year.
Let’s see how the numbers in the table look on a chart. The colors on the chart match the colors in the table.
The first year’s dividends are the same, but by 2025, the compounded dividend is 30% more. The compounding line curves upward, while the non-compounding growth stays straight.
The most common mathematical measure to describe compound growth is compound annual growth rate (CAGR). The CAGR for the table is 10% per year. When you are talking specifically about dividends, the term (as noted earlier) is called the dividend growth rate (DGR).
Are there stocks that raise their dividends by a constant percentage each year? Well, it’s unusual to find a stock that increases its dividend by exactly the same percentage each year, but it is not unusual to find stocks that grow their dividends by a significant average annual percentage for 10 years.
Here are a few real examples taken from David Fish’s Dividend Champions, Contenders, and Challengers. The middle column shows each stock’s 10-year DGR. The last two columns illustrate how those DGRs increased the dollar amount of the annual dividend over the 10 years from 2007-2017.
(Disclosure: I own Coca-Cola, Johnson & Johnson, and Lowe’s.)
Each company’s DGR is independent from its yield. Yield, you will recall from Lesson 1, is the annual dividend payout divided by the stock’s price. The company controls its payout, but it doesn’t control its price. Price is controlled by the market. That means that no company controls its yield.
That said, you will often see a loosely inverse relationship between yield and DGR. In the table above, for example, the lowest-yielding stock – Lowe’s at 1.8% – has had the fastest DGR at 19.3% per year, while higher-yielding stocks have slower dividend growth rates.
Here are the important takeaways from this lesson:
- Compounding = Earning money on money already earned.
- Companies compound their dividends by raising them each year. The pace of each year’s raise, or of a series of raises, is called the “dividend growth rate” or DGR.
- Compounding accelerates the rate at which dividends accumulate, like a snowball rolling down a hill.
- Yield and DGR are independent. The company determines its dividend amount and therefore its DGR, but its yield also depends on the market price, which the company does not control. A company with a low yield may have a high DGR, and vice-versa.
Please note that we haven’t talked yet about reinvesting the dividends. The compounding discussed in this article has been about the impact of the company raising the dividends that it sends you.
Dividend reinvestment gets into the topic of what you do with that cash once you receive it. We’ll talk about that second layer of compounding in the next lesson.
Dave Van Knapp
Click here for Lesson 5: The Power of Reinvesting Dividends
This lesson was updated 3/20/2018