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How to Use the Power of Compounding to Build TFSA Wealth

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Image source: Getty Images

Written by Andrew Walker at The Motley Fool Canada

Canadians are taking advantage of their growing Tax-Free Savings Account (TFSA) contribution space to build portfolios of investments to create wealth and generate passive income in retirement. One popular investing strategy involves owning top TSX dividend stocks and using the distributions to buy new shares.

Many companies give investors a discount on the shares purchased using dividends. The incentive is typically around 2% but can be as high as 5% in some cases.

How the power of compounding works with stocks

Each time a company pays a dividend, the investor can take the cash or use the money to buy new stock. When a stock has a dividend-reinvestment plan (DRIP) the investor can set it up so that the distributions automatically buy additional shares. There is no cost for the transaction, and the share price is often discounted. Most online brokerages give you the option to sign up for a stock’s DRIP, although the brokerages typically don’t enable the purchase of fractional shares. The difference in the dividend payout and the amount needed to buy full shares is deposited as cash in the account.

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Every time a dividend is used to buy stock, the holding increases, and the next dividend payment is higher, enabling the payout to potentially acquire even more shares, depending on the movement of the share price. Over time, the snowball effect can be significant, especially when dividends increase at a steady pace and the share price drifts higher.

A number of top TSX dividend stocks currently appear oversold and offer attractive yields.

Telus

Telus (TSX:T) trades near $24 at the time of writing compared to more than $34 at the peak last year.

Higher interest rates are making debt more expensive. This can put a squeeze on profits for businesses like Telus that spend billions on capital projects each year. Telus has also come under pressure due to challenges being faced by its Telus International (TSX:TIXT) subsidiary. The IT services and global call centre operations are being hit by a drop in revenue as global clients trim expenditures. There is an impact on Telus, but TIXT is a relatively small contributor to total revenue and cash flow.

Telus still expects consolidated operating revenue to rise at least 9.5% this year, and earnings before interest, taxes, depreciation and amortization (EBITDA) should grow at least 7%, so the drop in the share price might be overdone.

Telus has increased the dividend annually for more than two decades. Investors who buy the stock at the current level can get a 6% dividend yield. A $10,000 investment in Telus stock 10 years ago would be worth about $22,000 today with the dividends reinvested.

TD Bank

TD (TSX:TD) trades for less than $84 at the time of writing compared to $93 earlier this year and $108 at one point near the beginning of 2022. The pullback is due to investor concerns that a big recession could be on the way.

The U.S. Federal Reserve and the Bank of Canada are raising interest rates to cool off the economy and bring the jobs market back into balance as they fight to get inflation under control. If rates go too high and stay elevated for too long, there is a risk that the economy could take a big hit.

Higher debt costs could cause consumer spending to grind to a halt and force businesses to start cutting more jobs. A surge in unemployment would potentially lead to a wave of mortgage defaults. TD has a large Canadian residential mortgage portfolio, so it would likely feel some pain.

TD faces some headwinds and is already increasing its provision for credit losses, but the overall loan book remains in good shape, and TD has a large capital cushion to ride out tough times. Economists generally expect the potential recession to be short and mild.

TD has a compound annual dividend-growth rate of about 10% over the past 25 years. Investors who buy the stock at the current price can get a 4.6% dividend yield. A $10,000 investment in TD 10 years ago would be worth about $27,000 today with the dividends reinvested.

The bottom line on top stocks to build TFSA wealth

Telus and TD are good examples of quality TSX dividend stocks that have delivered attractive total returns for investors who use dividends to buy new shares. If you have some cash to put to work, these stocks look cheap today and deserve to be on your radar.

The post How to Use the Power of Compounding to Build TFSA Wealth appeared first on The Motley Fool Canada.

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The Motley Fool recommends TELUS and Telus International. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker owns shares of Telus.

2023