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. Continue reading rest of this article…