In my introductory blog post, I mentioned that dividend growth is all about the power of compounding. To understand why this is the case, let’s walk through a hypothetical example.
Suppose we can buy a stock called XYZ Corp. for $50.00 with a 2% yield. Once we buy the stock, we start receiving a dividend check every three months for $0.25 (four payments of $0.25 = $1.00, or a 2% yield on $50.00). To illustrate the potential impact of what happens when dividends grow, and compound over time, let’s look at what happens in a case where XYZ Corp. starts to grow its dividend at a healthy clip.
In our hypothetical example, let’s say XYZ raises its dividend 8% the next year. In that case, the dividend check rises to $0.27 every three months, or $1.08 for the year. In the first year, this isn’t very much of a difference, but if the company could continue with the 8% raise each year, over time the numbers can get interesting. If the company can maintain the 8% dividend growth rate, in 10 years, the $1.00 annual payment becomes $2.16. In 20 years, that number grows to $4.66. In 40 years, it’s $21.72. The end numbers differ significantly depending on the actual rate of dividend growth, so using a 6% assumption yields a much lower number just as a 10% number yields a much higher result. For the purposes of this illustration, let’s stick to 8% to keep the numbers simple, but this is not to suggest that 8% compounded dividend growth should be a general expectation or is easily achievable. On the contrary, finding companies with the ability to consistently grow dividends at healthy rates over long periods of time is the central challenge in dividend growth investing.
Returning to our XYZ example, if the dividends are reinvested back into the same company, that $1.00 payment grows substantially more. To keep things simple, let’s assume earnings also grow 8% per year and the price/earnings ratio remains constant over time. After 40 years, instead of $21.72 in annual payments, that number more than doubles to $45.26. Note how, in this particular example, the annual dividend payment will be close to the original purchase price of $50. Of course, the cumulative dividends received will be well in excess of that. That number works out to $486.85, just under 10x the original purchase price. Again, these numbers vary significantly with slight changes in the expected annual growth rate, so the actual growth rate achieved will be the ultimate determinant of how well, or poorly, this approach ultimately does.
Moving on from the dividends themselves, under the scenario above, the underlying stock itself will have grown in value from $50 to $2,489.26. Again, this is highly dependent on the assumptions we used, such as the earnings growth matching the dividend growth and the PE remaining constant. But, the point here is the underlying shares have the potential to grow in value too. This is where the potential benefits of dividend reinvestment in stocks really stand out versus something like bonds, where the face value (what is returned to the holder at the end) remains constant. I note, however, that the opposite is also true – when things don’t work out, such as the case of a dividend cut or the company’s growth substantially slows, this can negatively impact stocks in a way that bonds are not affected. I expect to cover more on this in later blog posts, but from this example we can begin to understand some of the potential benefits of dividends, dividends that grow, reinvesting those dividends and the compounding effect. When these work together, they have the potential to form the cornerstone for a long-term investment plan.