Stock Dividends: The Power of a Dividend Reinvestment Plan
When it comes to investing, the stock market is a great place to start. Unlike some types of investments, such as real estate, the stock market has a low barrier to entry. In other words, you do not need substantial resources to begin investing. In fact, you can start investing with less than $100. When you buy stock, there are two basic ways to grow your money. The first is appreciation. If you buy 20 shares of stock at $25 per share and the price is $35 per share three months later, the stock has appreciated by $10 per share or $200 total. However, you do not actually realize any gain until you sell the stock. Capitalizing on an increase in the value of the stock follows the principle of buy low, sell high. However, there is a way to make money from your stock without having to sell it. The second way to make money from stock is dividends, which are distributions paid by the company to shareholders based on company earnings.
Why Are Stock Dividends Valuable?
- Obtain a predictable source of income
- Realize gains without selling the stock
- Generate passive income
- Exploit compound interest by reinvesting the dividends
To realize a gain from an appreciation in stock price, you have to sell the stock. In the above example, just because the stock increased by $10 per share does not mean you made $10 per share. Rather, you simply have the same number of shares that you originally purchased that are valued at a higher price. The price could drop by $15 the next month. Therefore, selling the stock is the only way to realize the $10 gain. Once you sell, the gain is reported to the Internal Revenue Service (IRS) at which point you will be responsible for paying tax on the growth. However, if you want to employ a buy-and-hold strategy, which has the potential to experience substantial growth if you hold onto the stock for the long term, dividends are an important consideration. When a stock pays dividends, you will receive a specified amount every quarter. You can choose to take these dividends as a payment directly to your brokerage account, in which case they will be added to your cash balance. Alternatively, you can choose to reinvest the dividends.
What is a Dividend Reinvestment Plan (DRIP)?
The easiest way to reinvest dividends is by enrolling your stock in a dividend reinvestment plan (DRIP). Once enrolled in a DRIP, the dividends you receive from the stock are automatically utilized to purchase additional shares in that stock. If the dividends are not sufficient to purchase a full share, they will be used to purchase a fractional share, which then begins paying dividends. Thus, by using a DRIP, you take advantage of the principle of compound interest (i.e. you earn interest on your interest). For example, if the 20 shares of stock you own appreciated to $35 and pay a quarterly dividend of $0.25 per share, then the dividend payment will be $5 (20 shares x $0.25). This $5 will then be reinvested at the current price of $35 per share, purchasing you 0.143 shares of stock. In the next quarter (assuming the stock price and dividend remain the same), you will earn $5.04 in dividends on your 20.143 shares. Consequently, when you enroll in a DRIP, two things will happen. First, the number of shares you own will gradually increase. Second, your quarterly dividend payment will continue to grow. In most cases, companies will gradually increase their dividends, so the company may pay a quarterly dividend of $0.27 next year. While this $0.02 may not seem substantial, this represents an 8% increase in the dividend. Unlike stock prices, which can experience substantial fluctuations, dividends tend to be fairly consistent. As a result, you can project with relative certainty the dividend payments you will receive. This forecasting ability allows you to calculate how much money you will have available to reinvest each quarter.
Conclusion
Enrolling your stock in a DRIP is a great way to earn passive income, grow your investments (both the number of shares and the total dividend payment), and automate your investing. Once enrolled, there is no action required from the investor. Because dividend reinvestment exploits the principles of compound interest, the more shares you own, the faster you will see the power of compounding. While dividends alone are not a sufficient evaluation factor on which to base your investment choices, you should consider whether the stock you are purchasing pays dividends. If it does, not only can you benefit from an appreciation in the stock price, but you will also obtain a consistent revenue stream from the quarterly dividend payouts.
