The Power Of DRIPs And Dividend Growth

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 |  Includes: T
by: Michael Thomas

Dividend reinvestment programs are a great way to pave the path toward financial freedom if you are a long term investor. DRIP programs are offered by many companies and allow for dividends to be automatically reinvested into the company when they are paid to shareholders. When a dividend is paid, the shareholder gains an amount of stock value equal to the amount of the dividend paid, which is typically a fractional share. Over time, fractional shares add up and contribute larger and larger dividend payments because investors own more shares from those bought with dividends received. This is like putting your money to work for you in overdrive. If this growth pattern is enhanced by a good quality dividend growth stock where a company consistently increases dividend payouts annually, an investor can obtain significant returns and yield on initial cost.

Let's begin with an example using a high-dividend yielding stalwart such as AT&T (NYSE:T). AT&T is a Dividend Aristocrat, having increased its annual dividend every year for at least 25 consecutive years. The stock currently trades with a current dividend yield of 5.17% and an annual dividend payout of $1.76 per share. These are pretty good numbers and considering AT&T has consecutively increased annual dividends for at least 25 years we can make a reasonable estimation it will continue to increase dividends going forward as well.

AT&T has historically increased dividends at a compound annual growth rate (CAGR) of 5.10% over the last decade. Compound annual growth rates help smooth out growth rates over periods of time and are useful in determining historical growth rates. In the case of AT&T, the dividend CAGR has been decelerating in recent years with the three-year CAGR below both the five-year and 10-year CAGR. So while AT&T continues to increase dividend payouts every year it is doing so at a reduced rate. Figure 1 shows the rolling 3-, 5-, and 10-year dividend CAGR for the last 10 years.

Figure 1 - Rolling 3-, 5-, and 10-year dividend CAGR

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Now what? We have determined that AT&T currently maintains an annual dividend of $1.76 with a current yield of 5.17%, a history of at least 25 years of consecutive dividend increases, and a three-year dividend CAGR of 2.38%. We can now use these numbers to estimate what our investment will look like 10 years from now.

Our first analysis will assume that AT&T decides it is no longer going to increase dividends going forward but will maintain the current dividend payout of $1.76 per year from now on. This will produce a future dividend compound annual growth rate of 0%. This will serve as our worst-case scenario for dividends, although it is certainly possible for events to dictate a reduction of dividend by AT&T in the future. Figure 2 shows the analysis at a 0% CAGR over the next 10 years with a cost basis of a single share of T at a price of $34.06.

Figure 2 - 10-Year Dividend Analysis with 0% Dividend CAGR

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By the end of 2022 we can expect to have received $24.33 in total dividends paid for every share of T originally purchased and also own an additional 0.714 shares of T stock for every share originally purchased. The amount of cash returned through dividend payments, and subsequently reinvested, amounts to 71.45% of the original investment. The yield on cost is 8.75% and is directly a result of dividend reinvestment power as the dividend CAGR is 0%. Drawing on the dividend income produced after 10 years would give an investor 8.75 cents for every $1 invested in AT&T every year.

A second example will introduce a positive dividend CAGR. Instead of assuming 0% dividend growth we will use AT&T's historical three-year dividend CAGR of 2.38%. Dividend reinvestment working in conjunction with dividend growth will produce better results. Figure 3 shows the same analysis with a dividend CAGR of 2.38%.

Figure 3 - 10-Year Dividend Analysis with 2.38% Dividend CAGR

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With a 2.38% dividend CAGR working for us in addition to dividend reinvestment, total dividends received by the end of 2022 total $28.67 for every share originally purchased. An investor can expect to receive cash flows of 11.85 cents for every $1 in original investment annually.

A final example will use AT&T's historic 10-year dividend CAGR of 5.10%. At more than double the three-year dividend CAGR, this analysis should produce much better results. Figure 4 shows the analysis with a dividend CAGR of 5.10%.

Figure 4 - 10-Year Dividend Analysis with 5.10% Dividend CAGR

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At the end of 2022 investors will find themselves holding twice as many T shares as originally purchased. They will have received $34.94 in total dividends paid, which is more than the original share price purchased at $34.06. The income stream produced by this investment will yield 16.86 cents for every $1 originally invested.

Note that none of the analyses above takes into account any capital appreciation or depreciation in share price of AT&T. Dividends are assumed to be reinvested at an average price of $9.10 over the course of the study. A higher average price of reinvestment implies capital appreciation at the expense of reduced overall yield on cost while lower average price of reinvestment implies higher yield on cost at the expense of capital depreciation. In the first case, if a large capital appreciation of share value is realized over the 10-year period an investor may choose to reallocate the investment into another to increase income generated. In the second case, an investor may be faced with a paper loss but will have a higher yield on cost.

With the power of dividend reinvestment, it is a natural fit in the investment strategy referred to as dividend growth investing to seek out stocks with the right combination of high current yield and high dividend growth rate. A stock yielding 10% may not be as good an investment 10 or 20 years from now as a stock paying 5% with a higher dividend growth rate. In addition, since the strategy of dividend growth investing is based on a company paying a dividend and increasing the dividend paid annually, potential stocks need to be evaluated to ensure the best chances of success. Investing in a high-yield company is of no value for a dividend growth investment style if the dividend cannot be maintained. A dividend reduction by a company is a direct contradiction to what dividend growth investing is all about. This situation may not be completely avoidable but can be reduced by due diligence in researching the company's business health and financials.

While building wealth over time through dividend investing may not be as sexy as day trading or investing in risky high flying (and lower crashing) growth stocks, it is investing at its basic form. From a well-known definition, the value of a stock is the present value of all its estimated future cash flows. In large part, cash flows are returned to investors in the form of dividends. Leveraging dividend reinvestment programs with a dividend growth investment strategy can lead to very rewarding returns and future income streams. Due diligence in research coupled with patience, even through trying times of market volatility, are necessary to increase the chances of success in this strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.