Albert Einstein is reported to have called compound interest the most powerful force in the universe. Regardless of whether or not he ever really uttered those words, the ability to earn compound returns on your money is truly the most powerful wealth-generating force around. Many of the world's biggest fortunes were built that way, and it remains the most reliable method of helping us all build our own nest eggs today.
Unless you're already rich, you need all your money working for you -- including the cash thrown off by your existing investments -- in order to give compounding its power. After all, your invested cash only goes so far by itself. At 10% simple interest, you'd double your money after 10 years, triple it after 20, and quadruple your money after 30 years.
That's not bad, but compounding your wealth makes it grow even faster. After 30 years of compounding your money at 10%, you'd end up with more than 17 times your original stake. That would turn this year's $4,000 IRA contribution alone into nearly $70,000. It may not be enough to retire on all by itself, but when you combine it with your entire career's worth of investments, you can see how compounding can add up to a rather comfortable lifestyle.
How returns are born
The key to compounding is that it lets you have more money invested than you've actually contributed. If, for example, you invest $1,000 and earn 10% on it, at the end of the year, you'll wind up with $1,100. If you keep it all invested for the next year, your new base is $1,100 despite having only ponied up the original $1,000.
There are two engines that provide that compounding for you. The first comes from growth in the stock price, which is ultimately driven by growth in the company behind that stock. The second comes from the income thrown off by that investment. For you to receive income, that company merely needs to pay a dividend out of its existing earnings. Whether your return comes from growth, from a dividend, or from some combination of the two, it'll still compound for you, just the same. Better yet, the more you get in income, the less your total compounding rate relies on you finding fast growers.
And, let's face it, it's a heck of a lot easier to identify big companies with reasonable growth and decent dividends than it is to find the next Google
The balancing act
For us mere mortals, finding the right balance between growth and income gives us the best opportunity to compound our wealth. After all, investing successfully requires more from you than simply finding great companies. You've got to be willing to put your money into their shares, too, and as importantly, hold on as the market whips them around. If you can't do all that, then your potential profits will wind up in someone else's pockets.
When you're investing in companies that pay solid dividends, you don't need to simply rely on their growth to provide you all your returns. As long as those dividends are sustainable, you will see at least that payment and can use that cash to reinvest and compound further. So what makes a dividend sustainable? It's one that's:
- Easily covered by the company's operating cash flow
- Can grow at up to the overall company's expected growth rate
- Allows the business enough flexibility to maintain and expand its operations
Since dividends can grow over time as a business does, your money can compound all that much faster. By reinvesting your rising dividends, in fact, your money can potentially compound at a rate as high as the sum of your yield plus expected growth rate. This table shows just what that could mean to you:
|
Company |
Recent |
Five-Year |
Potential Compound |
|---|---|---|---|
|
Simon Property Group |
3.2% |
7.0% |
10.2% |
|
Dow Chemical |
3.6% |
8.0% |
11.6% |
|
Bristol-Myers Squibb |
4.6% |
8.1% |
12.7% |
|
Wachovia |
4.1% |
9.5% |
13.6% |
|
ServiceMaster |
4.0% |
12.0% |
16.0% |
|
AT&T |
3.9% |
10.0% |
13.9% |
Why it works
It may seem strange to see the claim that you could potentially compound at a rate as high as the sum of your companies' current yields and growth rates. Yet if you assume that:
- the companies you buy are fairly priced;
- stocks can rise in line with their earnings and dividends, keeping yields constant;
- investors can reinvest dividends without fees or current taxes (such as in an IRA); and
- reinvestments can be used to buy partial shares of stock,
then the logic behind that compounding rate becomes clear. Take a company trading at $20 per share that's expected to pay a $0.40-per-year dividend on $0.80-per-year earnings. It has a 2% yield. If it manages to grow earnings and dividends by 10% a year, the math works like this: If you buy 100 shares for $20, it would cost you $2,000. At the end of the year, you'd receive $40 in dividends. Because the company is expected to earn and pay out 10% more in the second year, its shares at the end of the first year are forecast to be 10% higher than at the beginning -- or $22. If you reinvest your $40 dividends into the stock, you'd buy 1.82 new shares at that price. Your total of 101.82 shares at $22 per share would be worth $2,240. That's 12% higher than your original investment of $2,000, with 10% coming from growth and 2% coming from dividend reinvestment -- the sum of your growth and yield.
Of course, things don't always work out that smoothly, but it does illustrate how you can get great compound returns from dividend-paying stocks even when they don't grow rapidly.
Get started now
Compounding your money over time in companies you'd actually be willing to own is the surest way to build real wealth. At Motley Fool Income Investor, we've assembled a collection of just such businesses, waiting for you to invest. Take the next 30 days for free to find out what they are and just how you can start making your money work for you. You've got nothing to lose by looking around, and you just might discover your ticket to a comfortable future.
At the time of publication, Fool contributor Chuck Saletta did not own shares in any of the companies mentioned in this article. Dow and ServiceMaster are Income Investor recommendations. AT&T is a former Stock Advisor selection. The Fool has adisclosure policy.
