Never invest a single penny unless you know what you want to accomplish. Know what the investment is capable of doing to that penny, at what risk level, in what kind of time frame, and determine if it fulfills these criteria in a satisfactory way. If it does meet your standards continue to analyze the investment and decided whether or not to pull the trigger. If it does not meet the standards you have set then take your money elsewhere. One very useful and easy to implement tool to assist in this task is known as the “Rule of 72.” Along with its cousins, the Rules of 69 and 70, the Rule of 72 is used to determine how long it will take for an investment to double your money. The Rule of 72 best applies to cases of annual compounding periods where the interest rate (or dividend growth rate) is 10% or lower. This makes well suited for comparing multiple possible income streams from dividend paying stocks and forecasting their future returns.
When looking at a stock as a potential addition to my dividend portfolio one of the key metrics that I use is the company’s dividend growth rate, particularly its five and ten year average (it is better to make your decisions based on trends then on what might be a one-time anomaly). In order to prevent inflation from cutting into the income stream I expect to receive from a company’s dividend payments I require that the payment increase every year and only very, very rarely will I accept an increase below the rate of inflation (typically only the case with high-yield stocks). Over time I expect the dividend income I am receiving from all of my stocks to reach a level that is sufficient for me to live off of without need of a primary job. In order for this to happen I am going to need my dividend stocks to double, triple, and possibly quadruple their payouts between the time I purchase shares in them and the time I stop reinvesting the dividends and start living off of them. The Rule of 72 serves as a quick calculation that can be done mentally to determine if a particular stock can meet this need.
Before getting into how to specifically apply the Rule of 72 when researching dividend stocks lets first review what it actually is. The way it works is that you use 72 as the numerator and interest/growth rate percentage as the divisor with the resulting figure representing the approximate number of compounding periods (in our case years) it will take to double the original principal. For dividend growth it can be explained as simply dividing 72 by the growth rate and voila, your answer is the number of years to double the payout. Simple right? Below is a chart showing how this works out:
Years to Double
Notice the mathematical beauty of using 72: most sustainable growth rates will not go beyond 12%, making the use of the Rule of 72 optimal, and of the whole numbers below and including 12 the following divide evenly into 72: 12,9,8,6,4,3,2, and 1.
I took the above table up to only 12% because the Rule of 72 starts to lose accuracy as growth rates go higher. Even so if you still wanted to apply it the math gets easier as the divisor gets higher (ex. 24 goes into 72 just 3 times). Just keep in mind the idea of sustainability: companies like McDonalds might be able to even manage a five year average growth rate of 20+% but eventually that rate will have to slow down otherwise it will far outpace a company’s earnings and/or the company itself will dwarf the actual economy it exists in. This is not to say to avoid high growth rates all together, simply to keep one eye on the future so you aren’t surprised when the increases slow down.
Now, without further ado, here is how you can use the Rule of 72 to plan your investment choices. Suppose you have twenty years to go before you retire and want to start living off your dividends. To double your money in eighteen years (I’ll stick to whole numbers) will require a growth rate of 4%. Think about this though: assume a conservative inflation factor of 3% and all of a sudden the real growth rate of your income is an anemic 1%. In order to clear this hurdle and still make the eighteen mark you should start looking for 7% growth rates (4% real return + 3% inflation = 7% required). Most of us though would probably prefer more than just a double on our income after eighteen years so lets see what a higher growth rate would get us. With a growth rate of 12% you can double your money at the six year mark, twelve year mark, and eighteen year mark. After twenty years you will have increased your income almost ten times! Inflation rains on the parade of course and adding in the extra 3% brings the required rate to 15%, which is much harder to maintain over such a long time frame.
Remember to set a goal for your desired income stream before you start buying dividend stocks. This will allow you to methodically seek out the best investment opportunities that will allow you to maximize the value of the money that you have invested. Part of your tool chest in this will be the Rule of 72 because you can use it to project if an investment will provide the future value that you desire. Additionally it can also be used as a backtest to determine if the company has indeed doubled its payments in timeframes you would expect it to based on its growth rate average. As always don’t restrict yourself to only one or two criteria when looking at companies to invest in and don’t reject companies on the basis of a single metric without knowing the full context of that company’s financial situation.