You Say Compounding, I Say Yes Please

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Includes: MO, RAI, T, UVV, VZ
by: Michael Thomas

Summary

Compounding is the powerful effect of earning interest on interest.

Dividend stocks reap the benefits of compounding when dividends are reinvested.

Selling options can speed up the process of compounding.

Compound Interest Picture Click to enlarge (source)

Many investors cite the importance of compounding for dividend and interest paying securities, but how many actually understand how it works? When the concept of money first came into existence it was primarily used simply as a means of making commerce easier. A shoemaker who needed a new hat didn't have to find a hat maker who needed shoes to make a deal. They could just give them money instead and it worked because everyone bought into the idea of that money holding value.

People started accumulating money and needed a safe place to store it. Enter the bankers, who eventually figured out they could make a ton of money by lending it to others at interest (along with fractional reserve banking). Compounding provided the icing on the cake where interest earned its own interest.

Individual investors don't have the ability to lend as banks do (with other people's money) but they can still take advantage of compounding by investing in dividend paying stocks. Compounding occurs when those dividends are reinvested (not necessarily in the same stock) and given the opportunity to earn dividends on dividends so to speak. Some simple examples highlight how it works and uses the surprisingly simple formula for compound interest below.

Compound Interest Formula Click to enlarge

(image source)

To illustrate the effects of compounding we'll use a simple one year bond at $1,000 par value with an annual interest rate of 4% as a theoretical investment and assume the bond is to be held until maturity. The simplest case is when the bond makes a single payment at the end of the one year period. Following the formula for compound interest yields the following,

Single Payment Interest

which shows that $40 in interest was earned. This isn't exactly a surprise as no compounding actually occurred. What if the bond made semiannual payments though? The result would be as follows,

Semiannual Interest

which shows an extra whopping $0.40. That 40 cents is the interest on interest earned from compounding. Similar exercises for quarterly, monthly, and continuous compounding show an increasing effect as the number of compoundings increases.

Quarterly Compounding

Quarterly Compounding

Monthly Compounding

Monthly Compounding

Continuous Compounding

Continuous Compounding

Notice that the formula for continuous compounding is different and uses the base of the natural logarithm, e. The $40.81 also means the maximum amount of interest you could ever earn from the example bond is $0.81. Also note that as the compounding frequency increases, the effective yield increases as well. Effective interest rates for each are as follows.

Annual

4.00%

Semiannual 4.04%
Quarterly 4.06%
Monthly 4.07%

Continuous

4.08%
Click to enlarge

So a bond that pays quarterly gets an extra 0.06% interest over one that pays annually. The extra 0.06% is gained through compounding interest on interest. That's how the magic works and the same can be applied to dividends. A simple application involves looking at some popular dividend paying stocks and making some assumptions based on historical averages to give an idea of how much an investor could expect to receive from holding them.

The examples that follow will use a holding period of 5 years, a reinvestment yield equal to the stock's average of current yield and 5 year historical yield, and an initial investment of $10,000.

Does AT&T Or Verizon Have Better Compounding Prospects?

Both telecommunications companies are widely held in dividend growth portfolios for their stability and commitment for annual dividend increases. Using a current yield of 4.04% and a historical yield of 4.57% for Verizon (NYSE:VZ) gives a projected reinvestment yield of 4.31%. Following the formula below,

ATT Compounding

shows that an investor could reasonably expect to receive $2,390.53 in dividends over 5 years. For AT&T (NYSE:T), a current yield of 4.48% averaged with a historical yield of 5.29% gives a projected reinvestment yield of 4.89% giving,

Verizon Compounding

The end result is that AT&T could earn an investor an extra $354.08 over Verizon, giving AT&T an edge if solely focusing on income prospects from the two.

Which Sin Stock Looks The Best For Income?

Tobacco companies are equally hated for the products they profit from and loved for the consistent high dividends they distribute. Popular stalwarts include Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Universal (NYSE:UVV) with Altria and Universal both increasing dividends for over 40 years. Altria currently yields 3.24% with a 4.60% historical average for a projected reinvestment rate of 3.92%. From the following,

Altria Compounding Altria holders could expect $2,153.67 in dividends over 5 years. Results for Reynolds American using a reinvestment rate of 3.71% are as follows,

Reynolds Compounding

and finally Universal at a reinvestment rate of 3.84% gives,

Universal Compounding

The end result shows Altria as the better investment for income of the three and may not come as a surprise to many who have held it over the years.

Conclusion

It's important to keep in mind that a formula is only as good as the inputs provided to it. Individual investors will invariably derive different results because they use different assumptions for unknown variables like expected reinvestment rates.

Compounding plays a very important role in dividend investment strategies and is a critical component of investing for income. I recently unveiled a public portfolio designed to increase the effects of compounding on dividend paying stocks through options. The "Most Boring Stock Portfolio on Earth" currently has a 7.5% annualized yield through option's premium. Details on the portfolio and the methodology employed can be found here. Current holdings are listed below.

Company Name Ticker Industry Put Strike Expiration Date Date Sold Option Length (days) Premium Received Option Requirement Annualized Yield Position Weight Current Stock Price Option Moneyness
BOK Financial Corp BOKF Banks $45 09/16/16 06/13/16 95 $49.34 $4,500.00 4.28% 4.07% $60.50 25.62%
CSX Corp CSX Transportation & Logistics $22 11/18/16 06/13/16 158 $42.34 $2,200.00 4.50% 1.99% $25.88 14.99%
United Technologies Corp UTX Aerospace & Defense $85 11/18/16 06/13/16 158 $116.34 $8,500.00 3.19% 7.69% $101.97 16.64%
Yum Brands Inc YUM Restaurants $65 10/21/16 06/13/16 130 $78.34 $6,500.00 3.42% 5.88% $84.31 22.90%
Ryder System Inc R Consulting & Outsourcing $45 11/18/16 06/13/16 158 $69.34 $4,500.00 3.60% 4.07% $62.12 27.56%
Fastenal Co FAST Industrial Distribution $37 11/18/16 06/13/16 158 $99.34 $3,700.00 6.31% 3.35% $44.72 17.26%
DeVry Education Group Inc DV Education $15 11/18/16 06/13/16 158 $135.34 $1,500.00 22.09% 1.36% $19.35 22.48%
VF Corp VFC Manufacturing - Apparel & Furniture $58 11/18/16 06/13/16 158 $199.34 $5,750.00 8.19% 5.20% $62.74 8.35%
Infinity Property & Casualty Corp IPCC Insurance - Property & Casualty $75 12/16/16 06/13/16 186 $294.34 $7,500.00 7.85% 6.78% $80.38 6.69%
Qualcomm Inc QCOM Communication Equipment $45 10/21/16 06/13/16 130 $76.34 $4,500.00 4.84% 4.07% $52.93 14.98%
T. Rowe Price Group Inc TROW Asset Management $65 10/21/16 06/13/16 130 $159.34 $6,500.00 7.04% 5.88% $71.59 9.21%
Polaris Industries Inc PII Autos $70 09/16/16 06/13/16 95 $219.34 $7,000.00 12.59% 6.33% $82.94 15.60%
Williams-Sonoma Inc WSM Retail - Apparel & Specialty $48 11/18/16 06/13/16 158 $314.34 $4,750.00 15.95% 4.30% $51.61 7.96%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/13/16 130 $14.34 $500.00 8.26% 0.45% $6.44 22.36%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/14/16 129 $67.96 $1,500.00 13.36% 1.36% $6.44 22.36%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/16/16 127 $43.65 $1,000.00 13.06% 0.90% $6.44 22.36%
Gap Inc GPS Retail - Apparel & Specialty $17 12/16/16 06/13/16 186 $135.34 $1,700.00 16.22% 1.54% $21.63 21.41%
ONEOK Partners LP OKS Oil & Gas - Midstream $21 10/21/16 06/14/16 129 $24.34 $2,100.00 3.31% 1.90% $40.66 48.35%
Analog Devices Inc ADI Semiconductors $48 09/16/16 06/14/16 94 $49.34 $4,750.00 4.09% 4.30% $55.95 15.10%
Flowers Foods Inc FLO Consumer Packaged Goods $15 10/21/16 06/14/16 129 $24.34 $1,500.00 4.66% 1.36% $18.55 19.14%
Brinker International Inc EAT Restaurants $40 10/21/16 06/14/16 129 $89.34 $4,000.00 6.45% 3.62% $47.15 15.16%
Tiffany & Co TIF Retail - Apparel & Specialty $60 11/18/16 06/13/16 158 $294.34 $6,000.00 11.70% 5.43% $59.53 -0.79%
AmTrust Financial Services Inc AFSI Insurance - Property & Casualty $24 09/16/16 06/13/16 95 $84.34 $2,375.00 14.35% 2.15% $24.29 2.22%
Bunge Ltd BG Consumer Packaged Goods $50 10/21/16 06/16/16 127 $84.34 $5,000.00 4.92% 4.52% $57.96 13.73%
Dominion Resources Inc D Utilities - Regulated $63 10/21/16 06/16/16 127 $54.34 $6,250.00 2.52% 5.65% $77.47 19.32%
Target Corp TGT Retail - Defensive $65 10/21/16 06/13/16 130 $257.34 $6,500.00 11.52% 5.88% $70.09 7.26%
TOTALS 138 $3,076.77 $110,575.00 7.52% 100.00% 14.80%
Click to enlarge

Disclosure: I am/we are short PUT OPTIONS IN ALL PORTFOLIO STOCKS LISTED.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.