Retire In Half The Time With Dividend Growth Investing

|
 |  Includes: ABT, AFL, EMR, ITW, JNJ, KMB, PEP, PG, RPM
by: Winning Formula

Most everyone has heard of the “Rule of 72” to calculate how long it takes for an investment to double when compounding at a given rate of return. For example, let’s say that you have $250,000 invested in a savings account that pays 4% interest. You can use the “Rule of 72” to calculate how long would it take for this account to double. The answer is to divide 72 by 4 which equals 18. Therefore, it takes 18 years for your investment to double from $250,000 to $500,000. To double again from $500,000 to $1 million at 4% interest would take an additional 18 years. Therefore, to turn $250,000 into $1 million would take 36 years at 4% interest with compounding in a savings account. So to get $40,000 of income from a savings account with a starting balance of $250,000 at 4% interest would take 36 years. Compounding, the reinvestment of return at the same rate was called the most powerful force in the universe by Einstein.

One of the aspects of Dividend Growth (DG) Investing is that you not only get the compounding of the dividend payments received like described in the savings account example of the “Rule of 72”, you also get compounding of the dividend yield as the company raises its dividend. The result is double compounding. So if we invest in a dividend stock, we get the compounding exactly like the savings account example turning $250,000 into $1 million in 36 years, but we also get a doubling of the benefit with the compounding of the dividend payment.

This double compounding with DG Investing turns the “Rule of 72” into the “Rule of 36”. The “Rule of 36” estimates how long it may take for your investment to double at a given dividend rate with reinvested dividends, assuming an equal dividend growth rate and equal stock price appreciation. The details of this calculation are demonstrated in the table below.

Year

Shares

Price

Yield

Dividend

New shares

Total Dividend

YOC

Portfolio Value

0

25,000

$10.00

4%

$0.40

1,000.0

$10,000

4%

$250,000

1

26,000

$10.40

4%

$0.42

1,040.0

$10,816

4%

$270,400

2

27,040

$10.82

4%

$0.43

1,081.6

$11,699

5%

$292,465

3

28,122

$11.25

4%

$0.45

1,124.9

$12,653

5%

$316,330

4

29,246

$11.70

4%

$0.47

1,169.9

$13,686

5%

$342,142

5

30,416

$12.17

4%

$0.49

1,216.7

$14,802

6%

$370,061

6

31,633

$12.65

4%

$0.51

1,265.3

$16,010

6%

$400,258

7

32,898

$13.16

4%

$0.53

1,315.9

$17,317

7%

$432,919

8

34,214

$13.69

4%

$0.55

1,368.6

$18,730

7%

$468,245

9

35,583

$14.23

4%

$0.57

1,423.3

$20,258

8%

$506,454

10

37,006

$14.80

4%

$0.59

1,480.2

$21,911

9%

$547,781

11

38,486

$15.39

4%

$0.62

1,539.5

$23,699

9%

$592,480

12

40,026

$16.01

4%

$0.64

1,601.0

$25,633

10%

$640,826

13

41,627

$16.65

4%

$0.67

1,665.1

$27,725

11%

$693,117

14

43,292

$17.32

4%

$0.69

1,731.7

$29,987

12%

$749,676

15

45,024

$18.01

4%

$0.72

1,800.9

$32,434

13%

$810,849

16

46,825

$18.73

4%

$0.75

1,873.0

$35,081

14%

$877,015

17

48,698

$19.48

4%

$0.78

1,947.9

$37,943

15%

$948,579

18

50,645

$20.26

4%

$0.81

2,025.8

$41,039

16%

$1,025,983

Click to enlarge

If your goal is to double your income with DG stocks, you can use the “Rule of 36” to “estimate” when your income may double from your current annual dividend payment. With a 4% current dividend yield on a $250,000 portfolio (assuming an equal 4% dividend growth and stock price appreciation), the dividend income would double in 9 years (36 divided by 4). Wow, nine years to double in DG stocks instead of 18 years to double in a savings account! If your income can double in half the time of the original rule, you can retire in half the time if you use DG stocks instead of a savings account. Also, your investment doubles again in another 9 years so you reach $1 million in the time it takes a savings account to double to $500,000. That is the power of double compounding.

Now that I have your attention, I need to set the record straight that double compounding is not just for DG investors. Theoretically, an investment will grow as fast as its earnings growth. Therefore, your portfolio should not grow faster with DG investing than it would with Total Return "TR" investing. With DG investing, the dividend is sent to the investor and then re-invested in the stock in this example. In TR investing, the company retains the earnings which should then be reflected in an increasing stock price. In both cases, the shareholder receives the benefit of the earnings growth. Dividend paying stocks are more conducive to demonstrating the "Rule of 36" example due to their dividend.

Stocks where the “Rule of 36” estimate would be most accurate are stocks that can maintain earnings growth equal to their dividend rate. Extremely high yielding stocks may not be able to sustain earnings growth above the dividend yield. Low yielding stocks and growth stocks may have growth rates above dividend rates. Stocks in the “sweet spot” of dividend yield, typically defined as the 3% to 4% yielding stocks, would be the most likely candidates to succeed with the “Rule of 36” estimate. This is because a stock with a yield in the sweet spot can grow its earning equal to its dividend yield for a long period of time. Some of the best “sweet spot” stocks in my portfolio include ABT, AFL, EMR, ITW, JNJ, KMB, PEP, PG and RPM. The following table shows each stock with its current yield, 5 year dividend growth rate, “Rule of 36” doubling estimate and actual length of time of its last total return double.

Ticker

Current Yield

5 Yr Dividend Growth

Rule of 36 Years to Double

Length of time of last double

ABT

3.6%

9.7%

10.0

13.3

AFL

3.0%

14.5%

12.2

11.1

EMR

3.2%

9.2%

11.3

8.0

ITW

3.1%

14.3%

11.6

10.2

JNJ

3.6%

8.9%

10.0

11.8

KMB

4.0%

12%

9.0

8.8

PEP

3.2%

12.0%

11.3

9.6

PG

3.3%

10.8%

10.9

9.8

RPM

3.8%

5.2%

9.5

7.8

Click to enlarge

As you can see in the above table, the “Rule of 36” estimate of the time it takes to double was close to the actual time it took each stock to double. Although this estimate was close, the real takeaway from this article should be the double compounding of stocks compared to a savings account rather than the preciseness of the “Rule of 36”. The bottom line is that the “Rule of 72” turns into the “Rule of 36” when an investor moves from fixed investments to growth investments. This double compounding may reward those who take the additional risk of stock investing to build their portfolio twice as fast as a fixed rate investment.

Disclosure: I am long ABT, AFL, EMR, ITW, JNJ, KMB, PEP, PG, RPM.