Compound Interest: The 8th Wonder of the World?

Charles is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When we were kids we learned about the 7 man-made wonders of the world.  Peter Lynch, famous among do-it-yourself investors for his stellar management of Fidelity Investments' Magellan Fund from 1977 until 1990, once referred to compound interest as the 8th Wonder of the World.  Why? Because the technique known as dividend reinvestment along with compounding interest has enabled many people able to retire comfortably and without financial worry.

The principle of reinvesting dividends in conjunction with compounding interest works like this: Let's say XYZ stock pays a 3% dividend. You reinvest the dividends in the underlying security to purchase more shares.  Most stocks pay dividends quarterly, so the first dividend payment would buy you 0.75% of your shares.  If the stock price is at $10, then your 100 shares are worth $1,000 and you would receive a $7.50 dividend payment the first time.  After reinvestment you now have 100.75 shares based on the $10 share price, and your shares are now worth $1007.50.  By the fourth quarterly payment, you will have 103.034 shares worth $1,030.34. Your effective yield is 3.34% due to compounding.

There are a few happy investors out there that followed a different path to retirement riches but still utilized the "buy and hold" method of portfolio management.  If you are old enough (and lucky enough) to have bought 100 shares of Wal-Mart (NYSE: WMT) when Sam Walton took his company public on August 25, 1972, and then were smart enough to hold these shares through the 9 stock splits (all 2:1 ratio) that occurred over the years, you would have 51,200 shares of stock with an approximately value of $3,699,200 at the current price of $72.25.  Wal-Mart just celebrated its 40th anniversary of public ownership, and you would now likely be either retired or getting ready to retire -- very comfortably.

Obviously, retiring on Wal-Mart’s success takes a lot of luck and patience, and there are a few other notable examples that we can either celebrate or distress over, depending upon whether or not you took action early in the game.  Bill Gates took Microsoft (NASDAQ: MSFT) public on April 13, 1986 and the stock closed at $28.  Nine splits later you would own 14,400 shares worth $437,760 at $30.40 a share.

Another famous example: Apple (NASDAQ: AAPL), with another famous quarterback -- the late Steve Jobs, deserves a look.  Apple went public on September 9, 1984 and closed that day at $26.50.  Apple only split three times over the years, but your 800 shares would now be worth $551,200 at $664 a share.

Lastly, to make my point I want to review Annaly Capital Management (NYSE: NLY), a widely known Real Estate Investment Trust (REIT) that pays a juicy dividend of about 15%.  Annaly began its public journey on October 8, 1997 at $9.33 a share.  Since the stock has never split your 100 shares would be worth $1,720, hardly enough to retire on.  But wait!  We need to revisit these four stocks and factor in dividend reinvestment with compounding.

In order to make the math less onerous, I'm going to use current yields for each stock and calculate added shares based on a starting point of 100 shares.  So the numbers may not add up to reality, but again I'm trying to drive home an important point about investing.

Wal-Mart began paying quarterly dividends 38 years ago, in September 1974.  After nine 2 for 1 splits starting in 1975 until 1999, you would have roughly 67,744 shares worth $4,894,500.  Reinvesting your dividends over the years at a 2.2% yield added 16,544 shares worth $1,195,300.  Thanks, Sam.

Microsoft's history includes 9 stock splits starting in 1987 and the last split occurring in February, 2003.  Conveniently, this split coincides with the start of dividend payments.  I compounded the dividend payments on 14,400 shares using a 2.2% yield, and assumed 100 shares were bought when it went public in 1986.  From February, 2003 until the present, you would have added 4,020 shares and would have 18,420 shares in total, worth $559,964.  Just to make your day, I worked with a young man that purchased 1,000 shares of Microsoft in 1987.  I wonder about him from time to time.

Apple split three times -- in 1987, 2000, and again in 2005.  From 1987 until 1995, the company paid a quarterly dividend.   I compounded the dividends using Apple's current 1.6% yield starting with 200 shares since the first split was around the time of the first dividend payment.  Those shares doubled in 2000 after the dividend payments had stopped, then again in 2005.  The ending shares total 909.01 shares worth $613,309 at the current stock price of $674.70.  Via the compounding method you accrue an additional 109 shares.

Lastly, Annaly Capital Management has always paid a huge dividend and has been paying dividends since its inception in 1987, or 15 years.  Your 100 shares would have grown to 910.513 shares worth $15,479. If you invested an additional $1,700 (100 shares) every year over the following 14 years, you would have 19,200 shares worth $330,240.

The point here is that you can't always be so lucky as to buy a Wal-Mart, Microsoft or Apple and then hold them to perpetuity.  However, you can employ the "8th wonder" to improve your retirement nest egg and lifestyle in your "golden years."   But you must start early and put time on your side.

CACody owns shares of Annaly Capital Management. The Motley Fool owns shares of Apple, Microsoft, and Annaly Capital Management. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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