We all are very much familiar with compound interest. We use savings account with fixed interest. What happens here is that an interest earned (from earlier time period) is added into the principle. Thus the next time period’s interest is somewhat higher. Traditionally, that’s what we have been used to. With a fixed rate of interest our earnings increase year after year.
Let us take an example.
- We deposit Rs 100 in a savings account with rate of interest of 5%, which gets compounded annually.
- In the first year, we will earn Rs. 5, in year 2 we get Rs 5.25, in year 3 we get Rs. 5.51, in year 4 we get Rs. 5.79, in year 5 we get Rs 6.08, and it continues.
- So the interest that we get keeps on increasing year after year.
Now if this is compounding interest, then what is compounding dividends? Before we try to answer this, let me explain what is the good quality dividend stock.
Among many others, the characteristic of good dividend stock is that its dividend increases every year. The rationale here is if earnings increase, the dividend will increase. Even if the percentage remains same, the companies tend to increase dividends with increase in EPS. This is what I call a good dividend stock.
Let’s us continue with above example.
- Let us consider that we purchased a stock of a good company that pays dividends (instead of putting our money into savings account).
- For ease of comparison, let us assume that this stock is paying dividends of 5%. Therefore, in the first year we will earn Rs. 5. This is same as our savings account. Now, a good dividend stock increases its dividends (while savings account interest rate is fixed).
- In our example, for ease of calculation, let’s us assume our stocks increases dividend by 10% every year.
- Therefore, in year 2 we will get Rs. 5.78, in year 3 we will get Rs. 6.71, in year 4 we will get Rs. 7.81, in year 5 we will get Rs. 9.17 and so on.
When we compare above two scenarios over the 5-year period, we earn Rs. 27.63 from our savings account. On the other hand, we earn Rs 37.47 from the dividend stock. That is a +35% difference. This is called compounding dividends.
Historically, it has observed that for any good dividend stock the dividend yield (w.r.t stock price in give year) tends to stay within a very narrow range. So if dividends are increasing every year, the only way to keep the yield in narrow range is that stock price also has to go up. In our example above, for 5% yield to be consistent year after year, at the end of year 5, the stock price could be Rs 183.44 (9.17/183.44 = 5%). In case of savings interest, our principle remains fixed.
It can be argued that this is hypothetical example and 5% dividend yield is never available. Is it so? Then you may be interested in my earlier post on yield-on-cost which uses a real example for not one company but three different companies.
So isn’t compounding dividends like “sone pe suhaaga”?
compounding dividends, savings interest, yield on cost