As a consequence of the recent downturn in the stock market, one investing philosophy that has made a remarkable recovery is dividend stocks. Rather than investing purely for capital appreciation (or the growth in stock prices over time), you invest to get paid a regular, quarterly dividend from your stocks. Besides the appeal of getting paid just for holding the stock, dividend payments also have the ability to grow extremely fast, thanks to a combination of compound interest and dividend growth.

In a normal compounding situation, like earning interest at a bank, the interest earned the first year can then be redeposited so it earns money the second year, and so on. As a result, the longer time frame we consider for compounding to work its magic, the more interest we earn. If we start with a $10,000 deposit in an account that yields 5% at a fixed rate (perhaps a CD), the first year it will earn $500 in interest (5% of $10,000). The second year, though, it'll earn $525, as both the original $10,000 and the $500 in interest from the first year will generate interest, assuming the interest was reinvested. After twenty years, the account will be earning about $1250 in interest, more than double the original interest rate, and in forty years, it generate roughly $3350 per year. (Of course, with the ravages of inflation being what they are, the ‘real' value of those payments will be much less; approximately $625 and $837, respectively. Still more than you were originally collecting even after accounting for inflation, but not much of a gain for forty years.)

So far, so good. But dividends have an advantage that bank accounts do not: they tend to increase over time. Let's look at a situation where we start with an investment of $10,000 in dividend paying stocks, again producing a starting yield of 5% on our invested money. This time, though, let's add in a yearly dividend increase of 5%, as well. For the first year, our results are identical: we get $500 in dividend payments. But, with year two, we end up getting about $551 in dividends; not only do we have a higher basis (since we reinvested our dividends, giving us $10,500 to start the year), but our dividend has increased by 5%, as well, raising the amount we earn from each stock that we own. Skipping ahead, as with our simple compounding example, and after twenty years, it's reasonable to expect a yearly dividend in the neighborhood of $3200 per year, and at forty years, about $22,500 per year, more than double your initial investment. (Again, inflation will erode the value of these payout amounts; the equivalent present values of these payouts are $1600 and $5625, respectively.)

As they say on infomercials, ‘But wait, that's not all!' Remember that stocks, unlike a savings account, can also have capital appreciation. In fact, because the company is steadily increasing the dividend payout, the stock will likely increase at least as much as the dividend rises. This should make sense; if the stock price remained the same as the dividend increased, then after fifteen years, the stock would be yielding 10%. After thirty years, the yield would be 20%, and by the end of our forty year period, the stock would be giving dividends equal to 33.5% of its price, more than one-third. Before it gets to any of those points, though, the rising dividend will encourage more investors to buy the stock, driving up the price and decreasing the yield, as yield equals the dividend divided by the stock price. Not withstanding the regular ups and downs of the stock market, the price of the stock will stay at an appropriate level according to the changes made to the dividend, with investors boosting or dragging down the yield as they buy and sell.

To show you just how these processes work, as well as where I got my numbers, have a look at a table showing the growth of money in one hypothetical dividend paying stock:

Here, we started with 1000 shares of stocks trading at $10 per share (because it made the math easy). The stocks have a 5% yield at the time of purchase (or $0.50 per $10 share) which grows by 5% each year. The dividends are calculated from the dividend yield and the number of shares, and then the dividends are reinvested at the going price per share. (We're assuming the stock will rise in value as fast as the yield increases, but no faster, just to make our math simpler.) The stock value then represents the capital gains from the stock as well as the value of reinvested dividends.

What do we see in this table? Well, the dividend per share and the number of shares both increased 6.7 times their starting values, the former from the company's dividend increases and the latter from reinvested dividends. (The fact that this value is nearly identical is purely a function of how I did the calculations and by no means indicates that this is a regular occurrence in real life.) What's more striking is that because the dividend depends on both the yield and the number of shares held, it has gone up more than 44 times the original value we were earning (6.7 squared is 44.89, which, if we multiply by our starting dividend of $500, gives a final expected dividend of around $22,477). Similarly, the value of our holding is (at least in theory) worth more than forty times our initial investment.

And THAT, my friends, is the power of compounding dividends; with a relatively small initial investment and plenty of time, we can easily build a rather sizable sources of regular income.