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Compounding with dividends

A closer look at the theory behind dividend compounding.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

What is compounding?

Albert Einstein may or may not have called compound interest the most powerful force in the world. But it’s certainly true that whoever understands it earns it, and whoever doesn’t pays it.

Compound interest is the interest you earn on interest you’ve already earned. It’s the alternative to ‘simple’ interest, under which your interest earns no interest of its own, and can make small annual returns multiply over time. It’s what makes long-term investing so good for your financial health.

Compounding takes time though. Consider a £10,000 investment generating 5% a year under both simple and compound interest.

Chart showing the effects of compounding in the short run

Scroll across to see the full chart.

After ten years simple interest would turn the initial £10,000 into £15,000, simply adding 5% of that £10,000 every year. At this point compound interest is only just starting to pull ahead on £16,289, but the difference is small and seemingly insignificant. But when we skip ahead to 50 years, we can see the magic at work.

Chart showing the effects of compounding in the long run

Scroll across to see the full chart.

Compounding dividends

Like interest, dividends can compound. Dividends are the portion of profits companies return to investors each year. If you use your dividends to buy more shares, and then use the dividends from these new shares to buy even more shares, the dividends will compound.

How important can compound dividends be to investor returns?

Very.

The graph below shows the growth of a £10,000 investment in the UK stock market starting at the end of May 1991. The eventual return has been broken up into the initial investment, capital growth and compounded dividends.

Chart showing the Importance of dividends over time in the UK stock market

Scroll across to see the full chart.

Past performance is not a guide to future returns. Source: Refinitiv Datastream, 31/05/1991 to 31/05/2021.

This is an example only, dividends from stocks and shares are not guaranteed and the value of investments can go down as well as up in value, so investors could lose money. These calculations don’t account for charges or taxes.

As you can see, compound dividends make up a small part of the picture early on but grow in importance as time goes by. In the long run, compound dividends have contributed the vast bulk of the total return.

Why we shouldn’t forget about taxes

Any dividends sent to HMRC can’t be used to buy new shares, and therefore they can’t compound. Over time, taxes can add up and seriously detract from returns.

The graph below shows the results of a £50,000 investment compounding a 4% dividend for 30 years under different tax treatments and with no capital growth. It has been cunningly set up so the initial dividend is £2,000 (4% of £50,000), which just so happens to be the current tax-free dividend allowance.

So initially, none of our four investors pays any dividend tax. But as the dividends compound, the taxes start to bite. Remember, the most you can pay into an ISA each tax year is £20,000, but if you’re a taxpayer and haven’t yet used your ISA allowance, then investing large amounts outside an ISA is a bit like making a voluntary donation to HMRC. This might be admirable but isn’t required. Tax rules can change and benefits depend on your circumstances.

Chart showing the effects of tax on compounding

Scroll across to see the full chart.

By the same token, dividends spent on share dealing commissions can’t compound either. HL can automatically reinvest your dividends at a reduced charge of 1%, subject to a minimum of £1 and a maximum of £10, compared to our usual charge of £11.95 per trade. It might be a small saving, but for a portfolio with lots of stocks it will add up over time.

Yields, safety and growth

We’ve looked at the power of compounding and the importance of doing it tax efficiently, but you might be wondering what type of stock makes a good dividend compounder.

Dividends are often expressed as a percentage yield, so a share that costs £1 and pays a 4p dividend would have a 4% yield. Obviously, a higher starting yield will compound faster than a lower yield. But remember, yields are variable and not guaranteed. There’s also more to consider than just picking the stocks with the highest yields.

For dividends to compound, they need to be paid. That might not happen if a company runs into difficulty.

As well as traditional measures of financial strength, dividend investors will often look at ‘dividend cover’. Dividend cover is the ratio of profits to dividends and tells you how much room to manoeuvre a company has before it might have to cut the pay-out.

A dividend cover ratio of 2 means profits are twice dividends, so the company is paying out half its profits each year. In general, we think a ratio of less than 1.5 indicates the dividend could come under pressure. Remember though, no dividend is guaranteed.

Another consideration is dividend growth. If a company can grow its profits, then it should be able to grow its dividends too. A growing dividend will compound that much faster than a stagnant one. A growing company will usually have a smaller initial yield, but over time it could catch up. And, growing profits could mean a growing share price, giving investors a double dip of both capital growth and dividend compounding.

What’s more, an unusually high dividend yield could simply be a function of a low share price. If the market loses confidence in a company the share price can fall, which pushes the yield up. However, this could be a signal that the company has problems and might be running into difficulty. If you’re looking at a stock with an unusually high yield, it’s worth being especially careful.

This article isn’t personal advice. If you’re not sure if a certain action is right for you, please ask for advice.

3 dividend stocks to add to an income portfolio

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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