It is the goal of many people to build enough wealth to put their kids through college, pay off their mortgage, be in a position to help their family and enjoy a financially worry-free retirement. Most people simply don't earn enough to accomplish all these goals without a little help.
If you don't have a generous relative or wealthy parents, you will need to devise a plan to help you reach your goals. Here's how I plan to do it with three very powerful concepts.
The Concept of CompoundingCompound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest — i.e. earning interest on interest.
With a constant interest rate your earnings spiral up each and every year when you reinvest the interest. Consider a $100 deposit earning 5%, compounded annually. In the first year you will earn $5, $5.25 in year two, $5.51 in year three, $5.79 in year four, $6.08 in year five, and so on.
Once I grasped this concept as a child, it forever changed the way I looked at money. Cash was no longer measured in terms of what it could buy me today, but what is its long-term growth potential.
But there is something even more powerful than compound interest. Unfortunately, something I didn't discover until I was much older.
The Concept of Compound DividendsCompound dividends are like compound interest on steroids! Let’s continue the above example and assume that instead of depositing money in an interest-bearing account, you instead purchase good dividend growth stock with a current yield of 5%. So, in the first year you will earn $5. Which is the same as the 5% interest-bearing account, but that is where the similarities end.
Good dividend stocks increase their dividends each year. In this example, let’s assume a 10% dividend growth rate. So you will earn $5.78 in year two, $6.70 in year three, $7.82 in year four, $9.17 in year five, and so on.
Comparing the above two scenarios over the five-year period, you will earn $27.63 from the interest-bearing account as compared to $34.47 from the dividend stock. That is more than a 35% increase!
As good as this is, it still gets better!
The Concept of Appreciating Dividend StocksGood dividend stocks’ yields tend to stay within a given range. Thus, if dividends are increasing each year, the only way to keep a consistent yield is for the price of the stock to go up.
In order to have a 5% yield in our above example at the end of year five, the stock would have to be worth $183.44 (9.17/183.44 = 5%).
Dividend Growth Stocks to ConsiderA dividend growth rate of 7.2% means your dividend income will double every 10 years — with no reinvestment of dividends.
Below are several stocks with a dividend growth rate in excess of 7.2%:
Chevron Corporation (CVX)
Yield: 3.1% | Growth: 7.3%
Chevron Corporation is a global integrated oil company (formerly ChevronTexaco) that has interests in exploration, production, refining and marketing and petrochemicals.
UniSource Energy (UNS)
Yield: 4.6% | Growth: 7.7%
Unisource Energy, through Tucson Electric Power Co., provides regulated electric service to over 392,000 retail customers in Southeastern Arizona.
Waste Management, Inc. (WM)
Yield: 3.7% | Growth: 7.9%
Waste Management Inc. is the largest US trash hauling/disposal concern.
Yield: 3.6% | Growth: 8.4%
Abbott Laboratories is a diversified life science company and is a leading maker of drugs, nutritional products, diabetes monitoring devices and diagnostics.
Yield: 3.1% | Growth: 9.4%
The Procter & Gamble Company is a leading consumer products company that markets household and personal care products in more than 180 countries.
Yield: 2.7% | Growth: 11.8%
Colgate-Palmolive Company (Colgate) is a major consumer products company that markets oral, personal and household care, and pet nutrition products in more than 200 countries and territories.
Yield: 3.7% | Growth: 13.3%
Intel Corporation is the world's largest manufacturer of microprocessors, the central processing units of PCs, and also produces other semiconductor products.
Yield: 2.8% | Growth: 13.3%
Wal-Mart Stores, Inc. is the largest retailer in North America and operates a chain of discount department stores, wholesale clubs, and combination discount stores and supermarkets.
Yield: 3.7% | Growth: 15.0%
ConocoPhillips Co. was formed in 2002 when Phillips Petroleum and Conoco merged and is now is the fourth largest integrated oil company in the world
Even if I had a generous relative or wealthy parents (which I don't), I wouldn't want to trust my financial future to what they might or might not do. Especially not when I can take charge of my own future utilizing the concepts above. Dividend compounding, it doesn’t get much better than that!
Full Disclosure: Long CVX, ABT, PG, CL, INTC, WMT, COP. See a list of all my income holdings here.