This is a guest post by Derek Foster, author of the popular book “Stop Working, Here’s How You Can!”
Throughout my 20s I never had a high-paying job, but I focused on saving some of everything I did manage to earn. To be fair, I could have saved much more quickly, but I also wanted to enjoy my time – so I spent a summer backpacking around Europe, a year traveling around Australia and New Zealand, and lived in Asia for a couple of years. But I also saved – religiously!
I was too much of an idiot to start my own business and earn big bucks, so I invested in the businesses of others – through stocks. I took calculated risks – even borrowing to invest at times, but the big break for me came during the tech stock bubble of the late 1990s. I never made a penny from tech stocks because I never invested in any.
However, while other investors chased the “easy” money from tech stocks, it opened up opportunities to buy boring income trusts at VERY cheap prices. At that time I was buying investments yielding 12-13% in some cases – all tax-advantaged due to income trust tax rules. These lush yields allowed me to earn a decent, tax-advantaged, passive income and retire at the age of 34.
I became a millionaire in my mid-30s through investing. But I slowly began to realize that high dividend yields were not the key to growing my wealth, but instead higher-growing yields (and earnings) were the key! This factor is why the rich get richer over time and the second million is so much easier to get than the first. Let me explain…
The Concept of “Look Through” Earnings
Warren Buffett has used the term “look-through” earnings to account for the earnings of the massive stock portfolio at Berkshire Hathaway. The concept is simple. For example, Berkshire owns billions of shares in Coca-Cola, but the company only counts the dividends as income (for accounting purposes). However, Coke might only be paying 50% of income in dividends and the remainder is being reinvested in expansion or used to buy back shares.
So in reality, according to Buffett, over time Berkshire is becoming wealthier at the rate of Coke’s earnings even though accounting only counts dividends in Berkshire’s earnings. In other words, as part owners of Coca-Cola, whenever Coke invests in new plants or expands its business, Berkshire is becoming wealthier (which will be reflected in the stock price over the long-term).
How Does “Look Through” Earnings Apply to You?
It’s the same thing with you if you’re an investor. Think about this…
Suppose you are on a “million dollar journey” and you work and earn $100K per year, so let’s say $70K after taxes. If you save $30K and live on $40K, you would be gradually moving towards you million dollar goal…
Now let’s suppose you earn $40K per year in dividends (and pay little or no tax depending on your situation). Let’s assume your stocks have an average of a 40% payout ratio with the other 60% being reinvested in your companies – so you’re in essence accumulating wealth at the rate of $60K per year!
From this, it only makes sense that even though you are spending every last cent of your income, you will still accumulate another $1 million much faster than working for it! This is the reason the rich always get richer – automatically (unless they spend their capital).
This realization has allowed me to travel around North America for a year with my family and not worry if I spend every last cent I earn (even though “paying myself” is ingrained as this was the key to my financial freedom). My stocks are doing the heavy lifting of wealth accumulation for me!
My portfolio has a payout ratio of around 35% with dividends increasing annually at a pretty good clip. This means that over 60% of my “look-through” income is quietly building wealth for me, WITHOUT taxes reducing its growth! Many people have asked why I chose the stocks I did and this is the reason I did…I want to build wealth without having to save any more money.
The second million is much easier!