Dividend Reinvestment: Do It

Dividend reinvestment is a systematic method of accumulating shares of a stock that pays a dividend. Most investors use dividend reinvestment as part of a long-term buy-and-hold investment program. After you purchase a stock, simply enroll in the dividend reinvestment plan (DRIP) and your dividends will be automatically used to purchase additional shares. Also, you may send voluntary contributions to purchase additional shares.

During the time you hold the stock and reinvest dividends you are practicing dollar-cost averaging. At higher stock prices, the dividends buy fewer shares, but at lower prices they buy more shares. You win in the long run as long as the current stock price is greater than your average cost per share. For example, if you own 100 shares at an average cost of $10 per share and the current stock price is $20, you're up $10 per share or $1,000. But if your average cost is $10 and the current stock price is $5, you're down $5 per share or $500.

Because dividend reinvestment increases the number of shares you own, in a rising market the market value of your holdings will be greater than if you didn't reinvest dividends. However, if the stock price declines for a long period, the value of your investment will decline, and you can still lose money. Reinvesting dividends can help to reduce losses, but it may not eliminate them.

Because you pay taxes on dividends, consider putting dividend reinvestment stocks in a retirement account so you can shelter the dividends from your current tax liability.

This discussion includes five examples of dividend reinvestment for stocks owned by Richard Howard. Therefore, we will describe the examples in his words. All the data are actual numbers taken from my dividend reinvestment account statements. The DRIP summary table illustrates the results of dividend reinvesting for one mutual fund and four stocks.

As you study these examples, note how relatively modest amounts of investment dollars produced handsome returns.

I opened an Individual Retirement Account (IRA) in 1987 with the Vanguard Group and bought the Vanguard 500 Index Fund (VFINX), which is a low-fee index fund that tracks the S&P 500. The fund pays distributions in the form of dividends and capital gains.

In 1987 I invested $1,513 in eight purchases and bought 58.979 shares. On December 28, 2005 the account market value was $10,347.94. Without the reinvested distributions the account would have been worth $6,830.95. Reinvestment of the distributions increased the number of shares by 51.49% and thus the account value by 51.49%.

American Express (AXP) is a financial services company best known for its American Express charge card. Its current dividend yield is only 0.9 %. I included AXP here to illustrate the negligible effect that a low dividend yield has on share accumulation. I bought 39.465 shares AXP in 1997 and the account total was 41.367 shares at the end of 2005, only a 5.75% increase in seven years. You don't accumulate shares very rapidly with low-yielding stocks.

Johnson Controls (JCI) manufactures control systems and automotive parts. JCI is a growth stock with a multi-year price upside. I invested $1,000 from 1995 through 1997. I have 62.299 shares. Adjusting for the splits, the reinvested dividends have increased the share total by 15.48%.

Wrigley (WWY), the well-known maker of chewing gum, has a steady history of growing earnings and paying dividends. The current yield is 1.7%. Wrigley is one of my favorite companies and I invested $2,600 from 1991 to 1996 to purchase 158.234 shares. Currently my account has 197.465 shares, a 24.96% increase due to dividend reinvestment. And the $2,600 investment has grown to over $13,364.43 primarily due to price appreciation, but helped by dividend reinvestment.

The saying "it takes money to make money" applies to dividend reinvestment. The more money you have in a dividend reinvestment account the more shares you'll accumulate over time. And if the stock prices increases as well, you get the additional benefit of owning more shares each at a higher value per share, thereby increasing the total dollar value of the investment.

The share accumulation table shows that you accumulate more shares the longer you reinvest your dividends. Also higher yielding dividends result in more shares. Obviously, the combination of high yield and lots of time results in some very impressive shares amounts.

The table values assume you start with one share of any stock. Each column heading shows a separate dividend yield. The body of each column shows the number of shares you will have after reinvesting the dividends for specified number of years.

For example, assume the dividend yield is 4 percent. For each share you own, in 5 years you will own 1.22 shares. In 30 years you'll own 3.24 shares. If you keep the stock for 50 years, you'll accumulate 7.11 shares for each original share. That's over seven times as many shares for doing nothing but filling out a dividend reinvestment form. If the dividend yield is 5%, after 50 years you'll have increased your shares 11.47 fold.

It's easy to reinvest dividends. But always inquire about the fees associated with reinvesting dividends because some plans charge hefty fees. Remember that any fee, no matter the amount, reduces your profits.

Always inquire about the fees associated with reinvesting dividends because some plans charge hefty fees. Remember that any fee, no matter the amount, reduces your profits.

The Dividend Book is a compilation of articles from buyupside.com about dividends and dividend reinvestment. It is a PDF file that you can read for free.

Conclusions and Recommendations

Dividend reinvestment is a conservative method for the patient investor who wants to accumulate shares of a stock for the long term. It is not a get-rich-quick investment scheme. To help you make money, follow these recommendations:

Buy stocks with a stable or increasing dividend.
Check the dividend payout ratio, dividends/ earnings. Check if a high ratio (greater than 80%) can be sustained.
Consider selling the stock if the company decreases or terminates its dividends or radically changes it business focus.
Monitor the stock's price pattern. Buy shares with new money when the stock price falls temporarily if the stock is on the upside.

Consider selling the stock if it's made a bubble top.
Systematic accumulation of shares through dividend reinvestment of a well-managed, financially-sound company can help increase the value of your portfolio.

For more information about dividend reinvestment read All About Dividends, Dow Jones Select Dividend Index Fund, Dividend Reinvestment Portfolio, DividendAristocrats Pay Steady Dividends, and Mergent's Dividend Achievers.

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