Overview:

Albert Einstein is said to have said “Compound interest is man’s greatest invention.”, “Compound interest is the greatest mathematical discovery of all time.”, Compound interest is the eighth wonder of the world”, Compound interest is the most powerful force in the universe”, and “Compound interest is more complicated than relativity theory.” [1] Ask Warren Buffett for the single most powerful factor behind his investing success, and he’d respond “compound interest” — without skipping a beat.[2]

Purpose:

The purpose of this article is to discuss one investing topic, dividend reinvestment. Dividend reinvestment holds to the power of compound interest.   

Assumptions:

As discussed in other articles, a dividend is a repayment from a company to its shareholders. Typically, an investor could either get that dividend in cash or allow for a reinvestment of the dividend. A reinvested dividend is something that allows the owner to take that dividend and buy the number of shares equal to the current price of the stock. Reinvested dividends take form of compounding interest in that if you reinvest dividends over time, your total shares will continue to grow. To explain how this works, let’s work through a problem together with the following assumptions for you as owner of MFC Company:

• The current stock price will be $100;
• We’ll have $10,000 to invest at Day 1 of year 1 (thus we’ll be able to buy 100 shares – $10,000 divided by share price of $100); and
• Dividends will be paid out yearly at $4 per year, a dividend yield of 4% (calculated as $4 per share divided by the current price of $100 per share).

Analysis # 1 – Flat Price – 10 Years:

In this analysis, we’ll assume that the share price will not change during the 10-year period.

Investor 1 

• Will take the cash and not reinvest the dividends.
• The investor will get $4,000 in cash (100 shares * $4 per year * 10 years).

Investor 2

• Will reinvest the dividends into more MFC ownership.
• By end of year 1, this investor will have 104 shares. Which is recomputed as follows:
  • 100 shares * $4 per share, which means $400 in cash
  • $400 divided by $100 per share means 4 extra shares to be purchased
• By end of year 2, this investor will have 108.16 shares, which is recomputed as follows:
  • 104 shares * $4 per share, which means $416 in cash
  • $416 divided by $100 per share means 4.16 shares to be purchased
• And so on, by the end of year 10, the investor will own 148.02 shares

Investor 1 would have a total investment worth $10,000 plus $4,000 in cash dividends for a total of $14,000.

Investor 2 would have a total investment worth $14,802.44 which is an additional $802.44 of income compared to Investor 1.

While this does not look like that much, Analysis # 1, is if there is no change in price.