Compound Dividends

What is Compound Interest
Compound interest is the result of previously earned interest earning yet additional interest. For example, if you were to put $1,000 into a savings account and earn a 5% return, at the end of the year your balance would increase to $1,050 (you earned interest of $50). If you left your investment in the bank for another year, and assuming the bank held its interest rate steady, you'd earn another $50, plus an extra $2.50. Why? Because you earned interest on not only your original balance, but also on the increased balance. It's this "earning interest on the interest" that defines compound interest. Think of compound interest as a snowball on a hill ... as the snow collects on the ball, and the larger the ball gets, the more snow it collects on each turn.

Dividend Compunding
Dividend compounding is similar to interest compounding, in that the investor can receive "dividends on dividends" if he or she uses the dividends earned to buy additonal shares of a dividend paying company. Is reinvesting the dividend difficult? No, but it is not always as automatic as a saving account. On the plus side, dividend compounding can be more rewarding than a savings account.

How to Reinvest Dividends
Reinvesting dividends can be done in an automatic fashion if the investor owns shares of a company which offers a Dividend Reinvestment Program, commonly referred to as a DRIP. If a company (for example Coca Cola) offers a dividend reinvestment program, the investor needs to contact the investor relations department at Coke and request the enrollment information. The paperwork is not difficult, and generally speaking, you'll only do it once. Most companies do not handle the paperwork or accounting of their DRIP programs, preferring instead to delegate this process to what's called a transfer agent. Transfer agents are reputable organizations, such as the Bank of New York.

Once you're enrolled in the DRIP program, your statements and activity is reported by the transfer agent, not the company. Don't let this process of enrolling and dealing with a transfer agent discourage you, as it really is quite easy and both the company and its transfer agent are there to help you. Once you are enrolled in a DRIP program, whenever you are paid a dividend - usually every three months - those dividends are used to purchase additonal shares in the company. So if Coke pays you $1000 in dividends, your DRIP account buys another $1000 worth of Coke stock at whatever price Coke stock happens to be going for on that day.

The other way to reinvest dividends is to do it yourself. For example, if Coke paid you a dividend of $1000, you'd use that $1000 to buy more shares of Coke in your own account. Buying and selling shares is relatively simple when done through a brokerage account and the commissions on buying and selling shares, if using one of the more popular discount brokers such as Fidelit or Schwab, is often less than $10 for modest sized transactions.

An additional consideration when reinvesting your dividends involves diversification. Whereas a company managed (or transfer agent managed) DRIP program implies the investor is reinvesting dividends in that same company, an investor wanting to diversify his or her holdings might choose instead to reinvest dividends into another company. Again using Coke as an example, if an investor received $1000 in dividends from Coke, he or she might want to invest those dividends in a different company, such as Microsoft, or Proctor and Gamble. Thus in this example, Coke is funding your position in Microsoft. And then of course, you'll want to reinvest those Microsoft dividends back into Microsoft, or perhaps somewhere else.

Regardless of how or where you reinvest dividends, the long term goal is to compound dividends by reinvesting them into ever increasing returns. If an investment account grows large enough either through time or good fortune, it's entirely possible to earn more in dividends that you can spend. While this is not commom, what is common is the concept of using dividend income to supplement retirement income in your golden years.

Why Dividend Compounding is Profitable
Dividends are a reflection of the performance of a company and a means of rewarding shareholders. As a company grows, typically, so does its dividend. This is the primary difference between compounding interest (paid by a bank), and compounding dividends.

With compounding interest, there is virtually no probability of company growth. In other words, your local bank is not going to conquer new markets and reward you for sticking with them by bumping up your savings rate. By the same token, your local bank is not likely to go bust, either. And if the bank were to go bust, most bank accounts are insured by the Federal Government.

With compounding dividends, the investor is pursuing the probability of growth, and this growth - while not guaranteed - can greatly exceed the returns offered by a bank. So whereas a bank offers you the protection that your principal investment is safe and cannot decline, a dividend paying company offers no such guarantee. On the flipside however, if the public company does well, your return will often far exceed anything offered by a bank. In short, you are taking a risk by investing your money in the management prowess of a particular company.

Where Growth Comes into Play
Companies are successful if they can profitably grow. For example, had McDonalds stayed with a single restaurant, it would not have been considered successful, except perhaps on a very limited scale. But of course McDonalds did not stay with a single restaurant - it grew into thousands of restaurants all over the world. This growth rewarded McDonalds investors as the share price and dividend moved higher over the years.

Dividends are a reflection of a company's growth, and as a company grows, its divided often grows as well. Companies such as Johnson & Johnson have increased their dividends every year for several years. If an investor owns shares in a company which pays an annual dividend of $1.00 per share, and the company is growing, it is likely that the investor may find that company has decided to increase its dividend to $1.05 per share - an increase of 5%. This is where interest bearing accounts (such as those offered by banks) and dividend paying accounts diverge. A bank is not expected to reward you as the bank grows, but the dividend paying company is expected to reward you. And companies routinely do this as a means of sharing their growth.

As companies grow, they often boost their dividends to keep pace with an increasing stock price. A simple illustration is best. Assume a company sets a dividend target pay-out rate of 4.00%, and the company share price is $50. A 4.00% pay-out rate, also referred to as a dividend yield, means the company will pay out something close to $2.00 per share in dividends. Now assume this same company grows, and the market price for its shares moves up to $75. In order for the company to maintain its goal of paying out a dividend yield of 4.00%, it must increase the dividend to $3.00 per share. In reality, neither the share price nor the dividend increase happens in such sharp increments, but the theory remains - companies can and will increase their dividends to stay within a range it feels is appropriate to its share price. In such a case, a dividend investor benefits not only from the increase in the dividend, but also an increase in the share price - a concept known as total return.

Summary
Dividend investing and dividend compounding is not without risk! Companies can go out of business and/or reduce or even eliminate their dividends. Recent history showed this behavior with certain companies involved in the production and transfer of crude oil. But assuming a company is successful at operating its business through prudent management, and growing their business, dividend investing and especially dividend compounding can greatly exceed the type of returns offered by compounding interest.