Many people invest in dividend-paying stocks to take advantage of the steady payments and the opportunity to reinvest the dividends to purchase additional shares of stock. Since many dividend-paying stocks represent companies that are considered financially stable and mature, the stock prices of these companies may steadily increase over time while shareholders enjoy periodic dividend payments. In addition, these well-established companies often raise dividends over time. For example, a company may offer a 2.5% dividend one year, and the next year pay a 3% dividend. It’s certainly not guaranteed; however, once a company has the reputation of delivering reliable dividends that increase over time, it is going to work hard not to disappoint its investors.
A company that pays consistent, rising dividends is likely a financially healthy firm that generates consistent cash flow (this cash, after all, is where the dividends come from). These companies are often stable, and their stock prices tend to be less volatile than the market in general. As such, they may be lower risk than companies that do not pay dividends and that have more volatile price movements.
Because many dividend-paying stocks are lower risk, the stocks are an appealing investment for both younger people looking for a way to generate income over the long haul, and for people approaching retirement – or who are in retirement – who desire a source of retirement income.
Contributing further to investor confidence is the relationship between share price and dividend yield. If share prices drop, the yield will rise correspondingly.
The Power of Compounding
Dividends often provide investors with the opportunity to take advantage of the power of compounding. Compounding happens when we generate earnings and reinvest the earnings, eventually generating earnings from the earnings. Dividend compounding occurs when dividends are reinvested to purchase additional shares of stock, thereby resulting in greater dividends.
To illustrate the power of compounding, let’s assume that someone asks you if you would rather be given $1,000,000 today, or be given one penny that would double in value every day for 30 days. At first thought, it seems logical that that $1,000,000 would be a better choice. After some number crunching, however, we determine that it would be better to take the penny and watch it grow for 30 days, as illustrated in the following figure:
|Figure 3: This figure provides an exaggerated illustration of the power of compounding. If you start with a penny on day one and double your “account” each day, you would be a millionaire within 28 days.|
As the figure shows, the first couple of weeks are pretty uneventful and it may seem impossible that one penny can grow significantly. Eventually, however, our “earnings” really start to take off, and by day 28 we would already have more than $1,000,000. Is this example realistic? No, not at all. While we might be able to double our money every day for the first couple of weeks, it is unrealistic to assume we could earn (or otherwise contribute) tens or hundreds of thousands of dollars each day after the first three weeks.
While this is not an example of how your money can actually grow, it serves to illustrate that, given time, money can grow, especially if earnings are reinvested. This is the power of compounding, called by Albert Einstein “the eighth wonder of the world.”
With dividend investing, the more often you receive and reinvest your dividends, the higher your eventual rate of return. To illustrate a more realistic example of compounding, assume you purchase 100 shares of stock XYZ at $50 per share, for a total investment of $5,000. The first year that you own the stock, the company pays one 2.5% dividend, earning you $125 in dividend income. If the dividend increases by 5% each year (5% of the previous dividend; not 5% of the stock’s value), your $5,000 investment would be valued at $11,226 dollars after 20 years (assuming there’s no change in the stock price and that you reinvested all of the dividends).
Now, imagine the situation is the same, but that the company pays a quarterly dividend (instead of the annual dividend in the previous example). Your $5,000 investment would grow a bit more to $11,650 over the next 20 years, for a total gain of 133.01%. Bump up your initial investment to $50,000, however, and you will end up with $116,502 after 20 years because of the power of compounding.
To take advantage of the power of compounding, you need:
- An initial investment
- Earnings (dividends, interest, etc.)
- Reinvestment of earnings
A dividend reinvestment plan, commonly called a DRIP, is a plan offered by a company that allows investors to automatically reinvest cash dividends by purchasing additional shares or fractional shares on the dividend payment date. This can be an excellent way for investors to take advantage of the compounding potential. Instead of receiving your quarterly dividend check, the entity managing the DRIP (which could be the company, a transfer agent or a brokerage firm) puts the money, on your behalf, directly towards the purchase of addition shares.
Many DRIPs allow you to purchase the additional shares commission-free and even at a discount for the current share price. DRIPs that are operated by the company itself, for example, are commission-free since no broker is involved. Certain DRIPs extend the offer to shareholders to purchase additional shares in cash, directly from the company, at a discount that can be anywhere from 1 to 10%. Because of the discount and commission-free structure, the cost basis of shares acquired in this manner can be significantly lower that if bought outside of the DRIP.
From the company’s standpoint, DRIPs may be attractive because the DRIP shares can be sold directly by the company – and not through an exchange. This means that the proceeds from the stock sale can be reinvested into the company. DRIPs can also allow companies to raise new equity capital over time while reducing the cash outflows that would otherwise be required by dividend payments. Additionally, DRIPs tend to attract shareholders with long-term investment strategies; as such, these investors may be more willing to “ride out” any rough periods.
From the investor’s perspective, DRIPs offer a convenient method of reinvesting. The primary disadvantage to shareholders is that they must pay taxes on the cash dividends reinvested in the company even though they never receive any cash.