Why You Should Always Reinvest Your Dividends
You already know that dividends are important because they can provide an investor with cash to pay bills, money to keep the lights on, food to put on the table or medicine to keep you healthy. Dividends can be used to pay for vacations, put a down payment on a house or donate to charity. Over time, however, those seemingly paltry amounts can grow into enormous sums if you reinvest them: that is, use them to buy even more shares of stock that pay dividends in turn. There are typically two ways to reinvest dividends, one of which is plowing them back into the company that paid them (this strategy can lower bankruptcy risk for any one firm but introduces more human judgment and chance for error in the process), the other is pooling them together and reallocating as if they were fresh cash like any other deposit.
For now, we'll focus on the first method for the sake of simplicity.
Reinvesting Dividends Can Turn a Slower Growing Company Into a Better Investment
In an article covering Jeremy Siegel’s book, The Future For Investors: Why the Tried and True Triumph Over the Bold and the New, you'll find an interesting statistic provided by the professor:
Between 1950 and 2003, IBM grew revenue at 12.19% per share, dividends at 9.19% per share, earnings per share 10.94%, and sector growth of 14.65%. At the same time, Standard Oil of New Jersey (now part of Exxon Mobile) had revenue per share growth of only 8.04%, dividend per share growth of 7.11%, earnings per share growth of 7.47%, and sector growth of negative 14.22%.
Knowing these facts, which of these two firms would you rather have owned? The answer may surprise you. A mere $1,000 invested in IBM would have grown to $961,000 while the same amount invested in Standard Oil would have amounted to $1,260,000 – or nearly $300,000 more - even though the oil company’s stock only increased by 120-fold during this time period and IBM, in contrast, increased by 300-fold, or nearly triple the profit per share. The performance difference comes from those seemingly paltry dividends: Despite the much better per share results of IBM, the shareholders who bought Standard Oil and reinvested their cash dividends would have over 15-times the number of shares they started with while IBM stockholders had only 3-times their original amount.
This also goes to demonstrate Benjamin Graham’s assertion that although the operating performance of a business is important, price is paramount.
Choosing to Reinvest Dividends in a Successful Business Can Result in Much Higher Compounding Rates and Wealth Creation
The choice to reinvest your dividends can even make a huge difference when examining a single firm in isolation. Say you decide you want to put $100,000 into one of the world's biggest, most respected medical, pharmaceutical and consumer product blue chip stocks, Johnson & Johnson. The heirs of the company's founding family were on the newly established Forbes 400 list of richest Americans. It had gone public many decades prior, in 1944. It had long been considered one of the premier blue-chip stocks in the market, and it's as good a choice as any.
You buy the stock, paying a split-adjusted $2.8281 per share. What happens? Imagine two alternate universes.
In one universe, you decide not to reinvest dividends. Your $100,000 grows into $4,367,897 before taxes. This consists of:
- 35,359 shares of Johnson & Johnson at a market price of $93.39 for a total market value of right around $3,302,177
- Aggregate cash dividends of around $1,065,720
Another cause for celebration is that at the current dividend rate of $3.00 per share, you are set to collect $105,204 in dividend income over the coming twelve months.
In the other universe, you decide to reinvest dividends. Your $100,000 grows into somewhere around $7,062,245. This consists of 75,621 shares of Johnson & Johnson stock at a market price of $93.39
Due to your significantly higher share count - almost double the stock - you are set to receive $226,863 in dividend income over the coming twelve months.
Those seemingly small dividend checks did that. By reinvesting dividends, you ended up with $2,694,348 in in surplus wealth from the capital gains and dividends generated on the shares purchased with your original dividends, setting off a virtuous cycle.
That's real excess money and real excess income. The downside is that by reinvesting dividends you had to forgo the use of the income along the journey, losing out on 33 years of vacations, clothes, concerts, charitable donations, cars and other perks you could have enjoyed from your share of selling a few things in the corporate stable. If you were already affluent or rich, that may not have been a big deal. Otherwise, it was a considerable sacrifice.