There are a few different ways to handle dividends that are paid out by companies. Taking these dividends in cash can be the easiest approach if one is in retirement or looking to live off their dividends. For everyone else, the question of how those dividends should be reinvested is a relevant one.
Automatic dividend reinvestment is a very common way to reinvest dividends. I consider this to be where an investor automatically invests dividends back into the dividend paying stock to purchase additional stock. Automatic dividend reinvestment can be a great way to accelerate wealth. Consider the example of an investor who had invested in McDonald's (MCD) 10 years ago. An investment of $10,000 in McDonald's without dividend reinvestment would be worth close to $66,000, and provide you with an annual dividend income of almost $1800. An investor who had reinvested McDonald's dividends back into McDonald's stock would have an investment value of almost $73,400 and an annual dividend of almost $2500.
The power of dividend reinvestment can really be seen over a very long term time period. An investor in The Coca-Cola Company (KO) who invested $10,000 about 50 years ago would have had a stock value of almost $500,000. If you think that's impressive, consider the scenario where those dividend were reinvested. That same investor would have almost $1.75M in an investment in The Coca-Cola company.
These examples appear to make a strong case for automatically reinvesting dividends into the stocks in one's portfolio. Dividend Reinvestment Plans or (DRIPS) make it fairly easy for an investor to simply plough dividends back into their stocks and repurchase additional stock at fairly low cost. Companies including The Coca-Cola Company, Johnson & Johnson (JNJ) and McDonald's all have DRIPS, which make it very easy for investors to reinvest their dividends automatically and receive additional stock.
However, blindly reinvesting your dividend income into your portfolio irrespective of prevailing market factors doesn't make for the most optimized use of dividend income. I'm not just referring to situations where underlying company performance is deteriorating, and the dividend itself is at risk of being cut, which occurred in 2008 among financial dividend payers such as Bank of America (BAC) and Citigroup (C).
The mood of Mr. Market can create valuation opportunities at any point in time, which an investor can take advantage of with a more strategic, optimized dividend reinvestment strategy. Mr. Market's moments of panic can turn low yielding, high growth dividend stocks into high yielding, high growth dividend stocks.
Consider a portfolio that has American Express (AXP) and Verizon (VZ). Both are solid businesses with large moats surrounding them, but with very different stock profiles. Verizon is priced as a large cap income stock with limited growth, while American Express typically offers a much more modest dividend yield with a stronger growth profile. The growth rate of American Express dividends prior to 2008 was close to 14% per annum over the 5 year period.
In 2009, American Express was pushed down to irrationally low levels, such that its dividend yield was almost as much as Verizon. At its low point, American Express was offering almost a 7% yield, more than Verizon has historically offered. However, American Express had a historical dividend growth rate significantly above Verizon.
From a valuation perspective, one would argue that American Express was significantly undervalued in early 2009, arguably trading at a far larger intrinsic discount to fair value than Verizon. So while an investor could have continued to reinvest their dividends with an unchanged allocation into both stocks, they would have arguably been far better off reinvesting all dividend income generated by the portfolio back into American Express stock.
And just how would a $1000 investment in Verizon and American Express have performed in the 4 years since 2009? While both stocks have had fairly strong returns, a $1000 reinvestment in Verizon would today be valued at $1928 for a return of 93%. That same $1,000 investment in American Express would be worth a current investment value of $4,950, or a return of close to 400%.
Automatic dividend reinvestment in stocks over a sustained period of time is a good way to generate significant wealth in the stock market, particularly where the underlying business has strong competitive advantages. However, more selective reinvestment may help maximize returns by taking advantage of valuation opportunities that arise due to market mispricing during specific reinvestment periods.
Disclosure: I am long MCD.