You’ve just received a letter from the company you own stock in and they are asking whether you want to take advantage of their dividend reinvestment plan or not. What should you do? Should you reinvest your dividends back into the company or keep the cash instead?
If you are investing for the income and luurve that little dividend check every quarter in your mailbox then keep doing that. There is actually nothing wrong with taking the cash if that’s what you prefer. But if you don’t need it and want to increase your profits then re-investing your dividends back into the company is a wise move. Let’s see why.
The way dividend payouts work is that you are paid a certain amount per share that you own. So if you own 1000 shares at ten dollars each and the dividend yield is, for example, three percent per annum, then you’ll receive approximately four checks per year (depending on how often the company pays out and if they had any special dividends that year or not) totalling $300.
But let’s say that you chose the dividend reinvestment plan instead of taking the cash. And the company pays a discount on these shares of 10%. So at the end of the first year you were given around 33 extra stocks so you now hold 1033.
Now you get paid dividends on the 1033 shares of the stock that you hold. If you take the dividend re-investment plan again (and assuming that the stock price and yield remains the same for ease of maths) you’ll end up with 1067 shares of the stock. Each year the amount of stock that you hold will be increasing.
And because you are being paid on the ‘free’ stocks that you are receiving you get to use the power of compounding interest. Over time this can really build up and in five or ten year’s time you could have doubled or tripled the size of your investment (depending on the dividend payout of the company).
It’s been proven many times that over the long term most companies rise in price. Yeah there are exceptions and crappy times like now, but OVERALL most companies do increase in value. Your chances of choosing good companies that do this are much higher too if you can choose strong companies to begin with.
But even if they don’t increase and stay the same, or worse fall, then if you own MORE of that company then your loss isn’t as dramatic so it actually helps reduce the volatility of the stock market making it a win for investors.
And each year if you are increasing the size of your investment then the amount of profit that you are going to make (assuming a stock price increase) is going to increase substantially as well. Let’s use the above example and say that the company only rose 7% over the two year period (very conservative).
If you took the dividends as cash then you would still only have 1000 shares but they are now worth $10.70, giving you a profit of $700 plus the $600 in dividends that you would have received totalling $1,300.
But if you reinvested the dividends you’d now have 1067 x $10.70 = $11,416 giving you a profit of $1,416. $116 more profit than if you took the cash.
Taking the dividend re-investment plan is a smart move for investors that have time on their side and can take full advantage of the compounding interest and increasing number of stocks that you hold. And if more wealth is your ultimate goal then it’s probably a no brainer to take the plan. But like I said if you like the check and don’t want to give that up that’s ok too.
Do whichever option works best for you.