The best argument in favor of the reinvestment of dividends—particularly pertaining to companies that you know will be bigger and stronger ten years from now—is that your money immediately is put to productive use. If you choose to pool dividends together for a separate investment at a later date while sitting on cash, you miss out on the dividends (and price appreciation, if any) that occur before you get a chance to put your cash to use.
The classic Benjamin Graham quote on this topic is this:
“It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value.”
I was looking at Emerson Electric’s history as an investment when I had this in mind. Emerson Electric is essentially a smaller General Electric without the financial operations, and has been raising its dividend every year dating back to the 1950s. Over the past twenty years, the dividend has grown by an average rate of slightly above 8%. If you were collecting $0.11 per share annually in 1995, you’d be collecting $1.72 in 2014.
Someone who bought $25,000 worth of the stock two decades ago would have collected $29,700 in dividends and seen appreciation in the price of the stock of $104,000. In other words, you’d be sitting on $133,700 today, with $104,000 of it in Emerson Electric stock and $29,700 sitting there as a cash balance.
Had those dividends been automatically reinvested, your share count would have grown from putting those $29,700 in dividends to work. You would have ended up collecting $40,400 in dividends over the period due to putting your money in additional Emerson Electric shares, and because they have a market value of their own as well as generating more dividend income, you’d be looking at $122,000 worth of capital appreciation on your investment.
In exchange for dutifully reinvesting your dividends for two decades, you’d reach a point where your investment would be achieving a 17.1% yield-on-cost, producing $4,275 in annual income on your $25,000 despite collecting a little less than $800 in the initial year.
The reinvestment of dividends, in this case, added $10,700 in total dividend income that went your way because of your decision to reinvestment, and because those got plowed into new shares, you also saw $18,000 in additional wealth get created because the new shares purchased with reinvested dividends have a market capitalization of their own as well.
It should be mentioned, of course, that you wouldn’t let $29,700 in cash build up from your Emerson Electric dividend payouts over the past two decades. You wouldn’t just sit there with $800 in dividend income from 1994/1995 dividends and never touch again for two decades, so if you wanted to properly calculate the opportunity cost, you’d have to compare the results of your Emerson Electric reinvestment against any other investment you would have made with your Emerson Electric dividend income, and that’s the hypothetical question that would vary by investor.
Instead, knowledge of the power of reinvested dividends adds some insurance to the investing experience because they are never usually addressed in the total return figures you see reported with most companies—the current standard practice of reporting historical returns is to combine the capital appreciation with the dividends generated from a stock. So, if a $5 stock paid out $2.50 in total dividends and the price rose to $7.50 over a specific period, you would hear that the total returns were 100%. However, if you put those $2.50 back into more shares, the reality of your situation will actually be better than that 100%.
Someone who bought McDonald’s stock and collected the dividends as cash to spend over the past two decades would have achieved 11.2% annual returns, which is very nice. But if those dividends got reinvested into more shares, the total returns would have been 12.1%. A full percentage point adds up to a lot over two decades. It’s the difference between turning $100,000 into $794,000 or $937,000.
For someone who owned $10,000 worth of Chevron and collected the dividends as cash to spend, the total returns would have been somewhere around 10.8%, becoming just under $75,000. The reinvestment button would have made it $107,000 (the substantial difference is due to the fact that Chevron tends to offer both a reasonably high starting yield so the amount of income getting plowed into new shares is high, and it is also has a high growth rate such that the reinvested shares bought in the early years have an outsized effect on growth). Learning about the effects of dividend reinvestment with oil stocks is probably one of the best Aces a long-term, buy-and-hold investor can have up his sleeves.
Even though the results of reinvestment can be quite nice for a portfolio’s end result, the conclusion shouldn’t necessarily be that you must reinvest your dividends in all cases. The purpose of money is to delay gratification so that you can live a better life later, and there does come a point at which you say, “I need to reap some benefits.” Instead, I provide reinvestment information so you can make a better decision about how to allocate capital, and realize that you get some insurance returns that add a percentage point or two to the results you actually experience compared to the figures that get reported.