The Compelling Case for DRIPs

05/08/2012 9:45 am EST

Focus: DIVIDEND

Tyler Laundon

Editor, Cabot Small-Cap Confidential

If you have a decent time horizon before looking to tap into your income stocks, it's a good idea to look into dividend reinvestment plans, advises Tyler Laundon of The Daily Profit.

I'm far from a die-hard dividend investor, but the practical wealth-generating potential of reinvesting dividend payments is impossible to ignore. So while a significant portion of my personal stock holdings are small caps, I've always made sure to own a healthy number of dividend-paying stocks too (including small, mid, and large caps).

The carrot here is that using very conservative assumptions and buying household names, it's possible to double your money over 20 years—even if your stock trades totally flat.

I've recently realized that not many people understand how this is possible. In fact, some of my closest friends didn't know how to reinvest their dividends to begin with...before we got to talking about it.

That's got to change. I realize that a lot of people buy dividend-paying stocks to generate necessary income, and I'm not suggesting this isn't a good option. But it's worth stating that one of the guiding principles of investing is to forgo spending money now in order to have more later on.

So if you don't need the income, are younger and/or you plan to hold your stock for a long time (or give it to your kids or grandkids), I strongly recommend enrolling all of your dividend-paying shares in a Dividend Reinvestment, or DRIP, program. Doing so can make the difference between a little money now and a lot of money later.

Better still, it's essentially painless to do. Just contact your broker and instruct them to enroll your eligible shares in a DRIP. That should take care of it—you just sit back and accumulate shares as time goes on.

Reinvesting your dividends means you can potentially double your money, even in a flat market. To understand how this is possible, it’s best to use a simplified example with a few key assumptions:

  • You buy 100 shares of a stock that yields 3.75% annually. The stock trades flat for the next year.

  • After owning the DRIP-enrolled stock for one year, your ownership increases by 3.75%, to 103.75 shares. After one more year of trading flat, your 103.75 shares become 107.64 shares. After five years of trading flat, you own 115.87 shares, and after ten years you own 139.28 shares. At this point, you could sell for a 39.28% gain.

  • After 20 years, assuming the stock price hasn't moved at all (and you've done absolutely nothing), you'll own 201.27 shares—twice as many as you originally bought. Despite the share price trading flat, the compounding effect of reinvested dividends means the value of your initial investment has gone up by 101%.

While this is clearly an oversimplification, it's so easy to comprehend for a base-case scenario that I find it gets people's attention, mainly because a 3.75% yield is pretty attainable.

From here you can tweak the numbers to suit your risk profile. If you want to try to double your money in just ten years, your magic yield is 8%. You can come close to that with some utilities or master limited partnerships (MLPs).

Or if you are really aggressive and a bit more risk-tolerant, a 12% yield means you'll double your money in just over 7 years, again assuming your stock trades flat.

The implications here are pretty straightforward. You're not necessarily looking for a big rise in the share price, but rather an increase in your ownership of the company.

Of course, these are simplified examples that are unlikely in the real world. It's more likely that the share price will rise over time, resulting in a much larger total return. That higher share price could mean your reinvested dividends will purchase fewer shares, but solid dividend payers have a cure for this.

The ones you will want to buy should have established track records of maintaining a target dividend yield. This means they increase the amount of the dividend over time to keep pace with share price appreciation. So in a real-world scenario, your original “cheap” shares will likely yield far more than they did when you first bought them, while your “more expensive” reinvested shares will generate whatever the stock was yielding at the time you acquired them.

The math on this gets pretty complicated, since you have to compound reinvested dividends at different rates in a real-world example, so I won't get into that here.

But we can look at a few examples, starting with Exxon Mobil (XOM), which paid dividends of 92 cents per share in 2000, when the stock closed the year at around $34. If you bought those shares and held them until today, the current yield would be 6.7%, an increase of more than 100% from the 2.7% you would have earned at the end of 2000.

Poking around on the web, I've come across a few examples that I haven't back-checked, but I believe to be accurate. One of the more interesting ones is that, theoretically, if you purchased $2,000 worth of Philip Morris (PM) stock in 1980 and enrolled in a DRIP, 24 years later you would have had nearly $300,000 worth of stock. All you had to do was, well, nothing. Just buy the shares and forget about them.

Like I said, enrolling shares in a DRIP is painless—just contact your broker and it's free. After you do so, all future dividend payments will be reinvested in new shares of stock (even fractional shares), without commissions. I've done so with all of my dividend-paying stocks, and I don't expect to remove them anytime soon.

Subscribe to The Daily Profit here...

Related Reading:

The Myth of Transparency
How's the Job Market? Look in the Mirror
What Happens if Germany Dumps the Euro?

Related Articles on DIVIDEND