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Reinvesting Dividends: Should You Enroll in a Dividend Reinvestment Program?

By Edited Mar 10, 2014 1 2

One strategy that many newcomers to investing often overlook is the difference that reinvested dividends have on the total return of an investment. Many times people who are starting out favor stocks that do not send payments home over those that have steadily sent payments to their shareholders over the course of decades.

A dividend is nothing other than a way for a company to send some of its profits to shareholders. Not all dividends are paid in the form of cash. Some firms award shareholder with stock dividends as well but these are different from the cash payments that many firms are known for. Those that are paid in cash can be reinvested at the investor’s command either by the company itself if the person or institution buys the shares directly from the firm or by a brokerage house if the stocks are owned through a brokerage account. The immediate effect of reinvesting these payments is that every payment increases the owner’s equity in the company.

One of the best things about reinvesting dividends is that it creates a dollar cost averaging effect that many times ends up in higher profits. Let us assume that a company pays a dividend of $1 every three months and that shares are valued at $100. The shareholder in this example owns 100 shares of the company for a total initial investment of $10,000. The break even price for the stock is $100 since this is how much the person paid for each. Every quarterly payment would be of $100 ($1 x 100 = $100) and would buy one additional share at $100 if the price of the stock remained the same and the dividends are reinvested. If the price of the stock is lower when the dividends are reinvested the result is that more shares will be bought. This process may result in partial shares if the brokerage house or company allows them. If not, then full shares are bought and any balance is sent to the owner or deposited in the account.

To continue the example, lets us imagine that the price of the stock plummeted to $75 and that the payout date is due. The owner would get 1.333 additional stocks bought at a price of $75 dollars. Remember that in this example we are considering that partial shares are allowed. Now the person has 101.333 shares and the total amount of money paid was $10,100 since we added $100 from the initial investment. The breakeven price is now $99.67 because of the dollar cost averaging effect. The equation would be $10,100 of total money invested divided by the number of shares which is 101.333 for a breakeven price of $99.67. Now to finish this example, imagine that the stock went up in value and is now worth $100 again. The investor decides to sell his investment and ends up with $10,133. There is an extra capital gain of $33 there that was the result of the dollar cost averaging effect of reinvesting dividends. This short example doesn’t really do justice to the power of dollar cost averaging but it will give you an idea of how profitable this strategy is especially for people that buy shares with the idea of owning them for many years. Remember that the more periods an investment compounds like this the better the end result especially if the investment goes down in value for a lot of periods then suddenly goes up higher than the breakeven price. The end result of many years of such dollar cost averaging is usually a lower breakeven price that translates into a higher return when the investment is finally sold or a higher share accumulation if the person decides to keep the stocks and use the income generated to cover his or her lifestyle.

So to answer the question in the title the answer is yes unless you need those payments to cover other things in life. It is also worth noting that building your equity in companies that send cash home may grow to a point that you can live off those payments and end up not needing to get up in the morning to go to work. But this takes time, a cash saving strategy and discipline.

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Comments

Sep 14, 2011 7:52am
CapstoneTrends
Yeah DRIP plans are awesome!
Sep 14, 2011 9:51am
RapidDash
They are a good way of increasing net worth over the years. Interest compounding in this case dividend compounding is very powerful especially if the securities are being held in a tax advantaged account such as a Roth IRA. Most of the dividend stocks I own are enrolled in a DRIP unless they are somehow overvalued. What I don't normally enroll on DRIPs are preferred stocks and REITs because I use the income generated by them to have cash available in my account in case a good buying opportunity presents itsself. But that is my personal way of handing those specific types of securities. I set preferred stocks in a DRIP only when they are trading at below their Par value and as soon as they return to their Par value or go higher I stop the DRIP. That is one of the benefits of using an online brokerage. You can enroll most types of securities in dividend reinvestment programs unless they are bonds. Still, you can enroll in a dividend reinvestment program mutual funds that hold only bonds.
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