Dividends 101 - The Beginner's Step-By-Step Overview of How Dividends Work
By Joshua Kennon
Full enrollment in a DRIP
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Practical Examples of Dividend Reinvestment Plans in Action
Direct stock purchase plans and DRIPs make it easy to compound your wealth because you can setup automatic investment plans that take money from your bank account to buy shares regularly. Dividends can be reinvested at little or no cost.
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Jane Smith owns 1,000 shares of Coca-Cola. The stock currently trades at $50 per share and the annual dividend is $0.88 per share. The quarterly dividend has just been paid ($0.88 divided by 4 times a year = $0.22 per share quarterly dividend). Before she enrolled in Coca-Cola’s dividend reinvestment plan, Jane would normally receive a cash deposit of $220 in her brokerage account. This quarter, however, she logs into her brokerage account and finds she now has 1,004.40 shares of Coca-Cola. The $220 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $50 per share.
Partial enrollment in a DRIP William Jones owns 500,000 shares of Altria group. The stock currently trades at $49.75 and pays an indicated annual dividend of $2.72 per share ($0.68 per quarter). William would like to receive some cash for living expenses but would like to enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in Altria’s DRIP.
When the quarterly dividend is paid, William will receive cash dividends of $136,000. He will also receive 4,100.50 additional shares of Altria Group giving him holdings of 304,100.50 shares (300,000 shares * $0.68 dividend = $204,000 divided by $49.75 per share price = 4,100.50 new shares of Altria Group).
Dividends on dividends
Why are dividend reinvestment plans conducive to wealth building
? Notice that William now has 4,100.50 additional shares of Altria stock. When the next quarterly dividend is paid, he will receive $0.68 for each of those shares. That additional income works out to $2,788.34. Those dividends will be partially reinvested in the stock, buying more shares which will pay more dividends.
In even the smallest portfolio, dividend reinvestment plans can result in substantial increases in value over extended periods of time. To demonstrate the power of dividend reinvestment through DRIPs, consider the example given in Jerry Edgerton and Jim Frederick’s August 1, 1997 Money magazine article, Build Your Wealth Drip by Drip: if you had put $10,000 in Standard & Poors 500 stock index at the end of 1985 and not bothered to reinvest your dividends, you would have had $29,150 by the end of 1995. Had you reinvested the dividends, however, your total would have been more than $40,000.
In other words, reinvesting those seemingly-small dividends resulted in an extra $10,850 over ten years. Assuming you continued to add to your principal investment and held those stocks for thirty or forty years, the difference could be hundreds of thousands of dollars or more.
More Information - Our Ultimate Guide to Dividend Investing
You're now ready to move on to our Ultimate Guide to Dividend Investing
. There, you'll learn advanced dividend strategies, how to avoid dividend traps, how to use dividend yields to tell if stocks are undervalued, and much more.