In our last lesson, we saw how an annual increase in a company’s dividends causes your dividend income to increase at a growing rate. This is called compounding. It results from the fact that each annual dividend increase builds upon the rate established by the last increase.
Compounding is like a snowball rolling down a hill, picking up new snow. As it rolls, it gets bigger at an increasing rate. Put another way, the bigger it is, the faster it gets bigger.
In dividend growth investing, that snowball effect from increasing dividends is the first layer of compounding.
You can add a second layer of compounding by reinvesting the dividends. Your dividend income, which is growing anyway, grows even faster if you buy more shares with the dividends.
You can reinvest dividend cash into the same stock that issued it, or you can use it to purchase shares of a different stock. Mathematically, it doesn’t matter, because the effect is the same: You will accelerate the rate at which your portfolio’s dividend stream grows.
Recall that compounding means earning money on money already earned.
Reinvesting dividends matches that definition exactly. The cash dividends coming in are “money already earned.” If you use that cash to buy more shares, the new shares will issue their own dividends. Those additional dividends are available only because you reinvested the original dividends.
To review, here are the two layers of compounding in dividend growth investing:
- First layer of compounding: Your dividend stream grows at an increasing rate, because your companies’ annual dividend increases build on prior increases.
- Second layer of compounding: You take those dividends and reinvest them – i.e., buy more shares. Those additional shares then generate additional dividends. Every dividend cycle, the process repeats, and more shares are added to your portfolio each time.
The end result is a growing snowball of dividends and shares that keep getting bigger at an accelerating rate.
We can see the impact of both layers of compounding by viewing a chart of dividend dollars per year that is produced by the calculator at Miller/Howard Investments.
For this simple hypothetical illustration, I input data for a stock that has a 3% yield and grows its dividend 5% every year. The initial investment is $1000.
The blue line shows your dividend stream if you don’t reinvest the dividends, and the orange line shows what happens if you reinvest the dividends.
- The blue line, without dividend reinvestment, curves upward slowly. That illustrates the first layer of compounding. The rise in each year’s income results from the stock’s annual dividend increase.
- The orange line shows the accelerating effect of reinvesting the dividends. The orange line curves up much faster than the blue line. The further out you go in time, the farther apart the lines get.
The mathematical measure for compound growth is called compound annual growth rate (CAGR). CAGR is the constant percentage rate of growth that would get you from the beginning point to the end point of a growth curve.
In real life, dividend growth rates vary from year to year. The CAGR pretends that the growth rate was equal every year, to arrive at the same result years later.
The CAGR of the blue line is 5% per year, which is the hypothetical dividend growth rate that I put into the calculator. Without reinvestment, the percentage rate of growth stays constant every year.
I computed the CAGR of the orange line. It is 8% per year. The higher rate is entirely the result of dividends being reinvested. Each reinvestment buys more shares, which generate more dividends. That’s why the orange line curves up and away from the blue line over time.
The analogy of a snowball rolling down a hill applies not only to your dividend stream, but also to how many shares you own. The orange line in the chart below shows how your shares increase when you reinvest dividends. In our simple example, 10 original shares become 30 shares in 25 years.
Without reinvestment, the blue line stays flat – you don’t get any additional shares.
Remember again why the orange line moves up and away. You didn’t add any new money to the portfolio to get those extra shares. The stocks you already own provided the money. The new shares came solely from reinvesting dividends that the portfolio produced on its own.
Now let’s look at a real company.
One of the most common dividend growth stocks is Johnson & Johnson (JNJ). JNJ has been increasing its dividend for 55 years. We’ll look at the last 11 full years (2007-2017).
Examining a real stock introduces real-world variability into the theoretical inputs that I used to generate the graphs earlier. Instead of a constant rate of dividend growth, we get the variable rate that the company actually provided. The shares purchased with reinvested dividends will come at the stock’s actual price, not a theoretical price.
Nevertheless, the principles still apply. On this graph of Johnson and Johnson, covering 2007-2017, we see JNJ’s real price (the black line) and its trajectory of dividend growth (the white/green line).
[Graph courtesy of FASTGraphs]
It’s hard to see, but the dividend line is curving upward slightly. That’s the result of JNJ’s dividend increases each year.
The following display shows how JNJ’s dividend, if reinvested in JNJ’s own shares, caused the dividend income stream to accelerate. This isn’t hypothetical, it actually happened. The figures are based on a $10,000 investment in JNJ. I’ve marked the display to identify the important points to notice.
Please note the following:
- The red circle shows the number of shares that $10,000 would have bought at the end of 2006, using JNJ’s actual price at that time: 151.47 shares.
- The green bracket shows JNJ’s dividend increase percentage each year, which varied between 5% and 11%. The CAGR at the bottom smooths out the different increases to a single equivalent annual average, which is 7.8% per year.
- The blue bracket shows the growing number of shares that resulted from reinvestment. Whereas the investor started out with about 151 shares, after 11 years of reinvestments he or she has about 210 shares (39% more shares).
- The gray circle shows the total dividends paid over the 11 years: $4959.53.
- The aqua bracket shows how the investor’s yield on cost (see Lesson 6) went up as the result of the 2 layers of compounding. By the end of 11 years, the yield on cost nearly tripled, from 2.5% to 6.9%.
What if the dividends had not been reinvested? The number of shares would have stayed flat and the income stream would not be nearly as large.
- At the end of the 11 years, the investor would still own the same 151 shares that he or she started with.
- The dividend increase percentages, of course, remain the same. They were determined by JNJ’s management (see Lesson 1), not by how many shares you own or whether you reinvest them.
- The total dividends paid over the 11 years would have been just $4059, compared to the $4959 that we got with dividends reinvested.
The results absent reinvestment are nothing to sneeze at. Annual dividends more than doubled. That’s from the first layer of compounding: The impact of the company raising its dividend every year.
Reinvesting dividends added the second layer of compounding. In 11 years, the annual dividend flow nearly tripled, as did the yield on cost.
If the table were extended another 10 years into the future, the rate of pick-up of additional shares and the speed at which the dividend stream grows would continue to accelerate. Fortunes have been built in exactly this way.
Important Takeaways from This Lesson
- As we saw in Lesson 4, companies that increase their dividends provide the first layer of compounding that increases your dividend flow each year.
- Reinvesting dividends adds the second layer of compounding. The reinvested dividends buy new shares, which produce their own dividends, in a repeating cycle of growth and reinvestment that occurs each time you receive and use them to buy more shares.
- This additional compounding accelerates the growth of your income stream beyond the growth that comes from the company’s annual dividend increases alone. The gap between the two widens as more years pass.
- Reinvesting dividends also increases the number of shares that you own.
- If you invest your dividends into the same company that delivered them, your stake in that company will increase every quarter. If you invest them into another company, you can start a new position with your dividend dollars. Either way, your additional shares will produce their own additional dividends.
Dave Van Knapp
Click here for Lesson 6: Yield and Yield on Cost
This lesson was updated 4/12/208