8 Cash-Generating Machines

Some money works harder than the rest. The bills in your dresser drawer, for example, are just sitting there, slowly losing their value to inflation. The bills you handed over for that new car have been transformed into an asset that will shrink in value over time. The bills that you invest in a great company will likely increase in value for you -- yay!

But you can do even better than that: Invest in companies that pay dividends and that increase them over time and your dollars will do some amazing things.

I'm referring to the power of reinvested dividends. It's a lot like the power of compounded interest, where every dollar of interest earned goes on to earn its own interest. With dividends, each one reinvested in additional shares of stock will kick out new dividend-producing shares.

Here's what I mean: Imagine buying 100 shares of a $50 stock that pays out $2 per share annually in dividends, for a 4% yield. In the first year, you collect $200 and have it reinvested in more shares. If the stock hasn't budged much, you may get four more shares, for a total of 104. That next year, the dividend is increased by the company to $2.20, and you collect $229 (104 times $2.20), which is reinvested in more shares.

That might seem like just what you'd expect, but look closely at what's happening. The dollars you invest in strong dividend-paying companies will buy more shares, which will in turn buy more shares, and so on and so on. It's a beautiful circle.

Portfolio candidates
To take full advantage of this wealth-creating process, look for companies that offer a meaningful dividend yield, and favor those that have been hiking their dividends significantly. For instance, let's take a look at the S&P 100's fastest dividend growers over the past five years to see if they deserve a berth in your portfolio.

Data: Capital IQ, Yahoo! Finance.

Of course, past dividend growth doesn't guarantee these high growth rates will continue. You'll need to examine the health of their balance sheets, looking for low or manageable debt. Ensure that the percentage of earnings being paid out as dividends (the payout ratio, that is) isn't too high. Less than 50% is very good, as low payout ratios make future dividend increases more feasible.

Dividends in action
Let's see just how powerful dividends can be, shall we? Below I've imagined dividing a $100,000 investment equally between our eight candidates (that's $12,500 in each). I've projected what the dividend income will be in 20 years based on the initial shares purchased now. For each company, I used half of its annual dividend growth rate from the table above, to be more conservative. (I cut UnitedHealth's rate by two-thirds, as it was so extreme.) After all, companies experience a slowdown in growth over the years.

The first year offers an average yield of just over 2%, but by year 20, you're earning almost 39% of your initial $100,000 investment in dividends alone. (Even if your dividends grow at a slower pace than the companies above, you can still rack up impressive gains.) Better still, if you'd reinvested your dividends along the way, they would have bought you more shares of stock that kicked out more dividends.

Tap dividend power
The power of dividends is truly amazing. They're a force to be taken advantage of -- especially around recessions, when prices are depressed.

And one of the niftiest things about dividends is how you can transform each one you receive into additional shares of dividend-generating stock. It's a lovely, profitable mechanism, and one of the best ways you can use your money.

Jim Royal sees the dividend play of a lifetime right now -- if you like any of his suggestions, add them to My Watchlist.