Over the last few years on my site I’ve posted monthly dividend income updates like these. Every now and then from these articles I receive a few questions from readers regarding my DIY approach to saving and investing – using primarily dividend paying stocks. Today’s post will tackle one of those questions.
Why do you focus on reinvesting dividends so much?
Great question. A big reason why my passive income to fund financial freedom is on the rise is largely because all dividends paid by the companies I own are being reinvested every month or quarter. Let’s revisit the dividend principle and why reinvesting dividends works.
Why dividends?
Companies can use dividends to pass on their profits directly to shareholders. They don’t have to, but many companies do. Why? A few things come to mind for me:
- It’s core to company strategy. Potentially there are no companies to acquire, maybe company debt is under control, and/or this is already a stream of cash to support new company products or services. The company feels it’s simply one of the best things to do with company profits – reward shareholders.
- The company is on sound financial ground. Most companies that pay a dividend, especially long-term (as in decades), have a stable business model. You really can’t fake dividend payments for very long. Companies that grow their dividend tend to have great cash flow – profits. As an investor, it’s to your advantage to own shares in a company that makes money, consistently, and makes more money over time. A reliable dividend is just one good sign of business strength because unstable companies cannot pay profits to shareholders for very long.
- They want to attract investors. This is akin to company strategy. Some investors are more speculative and like risks (not me). Dividend-paying companies can attract a certain type of investor – My Own Advisor. These investors like the idea of earning income from their investments the same way people go to work to earn an income. Eventually though these investors won’t have to work. The working will be done by their portfolio. The portfolio will pay out the income.
Why reinvest dividends?
So you know from the above companies that reward shareholders via dividend payments can be one form of investor return. Dividends are great but they are not everything – total return matters and dividends are just part of the total return equation. So why reinvest dividends? There is a simple answer to this question I use frequently: money that makes money can make more money.
A quick example using a stable dividend payer over the years: TD Bank.
I used a starting point of today (one share) and a recent stock price. I also used relative data, TD has grown their dividend by just under 10% over the last 10 years* but this amount was lowered in this example to be more realistic. Longrundata is one of my favourite sites for such data. (*Past performance is not indicative of future results though, and, I simply used these numbers as an example.)
As you can see from my quick example there is a significant difference in the annualized return with dividend reinvestment. You can also check out TD Bank’s share price calculator here.
How to reinvest dividends?
There are a number of ways dividends can be reinvested.
- You can use a “true” or “full” Dividend Reinvestment Plan (DRIP) using the company’s transfer agent. These are dividend reinvestment plans set-up with the stock company’s transfer agent (not a discount brokerage). You need to own at least one share of the company you want to DRIP, have that share registered in your name and own the share certificate. The share certificate can be mailed to you by your discount brokerage usually starting at a cost of about $50 + HST. You then take your share certificate and enroll it into the DRIP administered by the company’s transfer agent. This is lots of information for the new investor to absorb and digest – so check out this page on my site for further reading. This is the approach I started with (to own fractional shares of companies like TD Bank in my example) but no longer use.
- You can use the “synthetic” DRIP using your discount brokerage. These are dividend reinvestment plans set-up with your discount brokerage. In some cases, all you need to do is contact your discount brokerage and inform them about the shares you wish to DRIP. They’ll do the rest. This is the approach I employ now whereby I reinvest dividends as much as possible at my brokerage.
- You can use the “DIY” DRIP using your discount brokerage. Using this method, in your portfolio of stocks, you let the cash accumulate from the dividends and distributions paid until you decide to add to an existing position. I’m not the biggest fan of this approach but there is nothing wrong with letting cash accumulate in your bank account – from stocks you cannot DRIP yet – it’s the only choice you have.
Summary
Getting paid to be a shareholder, usually paid regardless how far the stock price falls in any given day, month or year, is a good feeling and it’s good for my bank account. This is why I focus on dividends so much. As of this month we’re on pace to earn $12,600 this calendar year from dividends – most of that tax-free thanks to investments inside our Tax Free Savings Accounts (TFSAs). We don’t dare spend anything today because you know from this post – money that makes money can make money – if you let it.
What’s your take on using dividend stocks for income? Do you have any further questions for me and my approach?
Mark — any interest in owning Dividend Growth Funds? Any idea of how they stack up against your hybrid portfolio?
I’m doing OK I think SST.
https://www.myownadvisor.ca/benchmarking-my-portfolio/
Time will tell if my performance continues!
Mark,
“Longrundata is one of my favourite sites for such data.”
I agree “longrundata” is a fabulous sire for determining annualized returns. However, they’re far from accurate for dividend info/returns on Canadian stocks. A prime example is the one you referenced above for TD. If you check the numbers for the Canadian listing (TD.TSX) longrundata shows several instances where the dividend appears to have been cut, the first being in 1999. All of the apparent cuts are in error as we know TD has never reduced their dividend in their history dating back to the mid 1800’s. The $ dividends longrundata shows for TD.TSX are actually in $USD post conversion. I don’t know why longrundata insists on doing this as TD’s dividends are paid in $CAD from the getgo.
That’s the challenge – finding accurate calculators. My post was just an example, showing how reinvested dividends can/will ultimately provide compounding power, but I can appreciate to Michael’s comments they lack accuracy.
I have no idea why longrundata insists on converting CDN stocks listed on CDN exchange that pay dividends in CDN money, are doing any sort of conversion. I would have to email the owner of the site to find out. I might 🙂
Thanks for your comment.
I suspect the TD calculator was more accurate which is why I also included it in my post. If TD’s calculator is totally off….then I’d like to know where to find a decent one!
By watching the dividend income grow, rather than the market value of ones investment, eliminates most of ones worries. I can clearly remember the panic I felt when the market dropped and the value of my holdings was down by over $100,000. Every day I hoped the prices would rise or wondered if I should buy more to reduce my cost. The relief when prices did go up and my regret of not buying when prices were low.
Those days are long gone and looking back I wish I had concentrated on the Income Growth from the beginning. Dividends from large, stable solid, and established companies are almost bond like. Sure there have been cuts, but they are rare. Monitoring your dividend income represents real dollars and provides you with a measurable projection of your future income. Certainly total return is part of the picture, but capital growth is not as predictable or can change quickly.
Total return is very important but as a retiree or semi-retiree in 10 years I won’t be able to count on capital gains for my income. I will prefer to use my dividend income to pay for expenses.
Nice summary Mark:
1. Another option for “Full Dividend” reinvestment is ShareOwners, the only broker offering it. They are not the best or cheapest broker, but for us retired folks who are not buying and selling the full reinvestment makes a big difference.
2. By reinvesting dividends you get additional shares with small investments and don’t have the money sitting around. If one is investing new money on a regular basis, than adding the dividends allows one to buy when and what they want.
3. Reinvesting dividends improves compound growth over the long term.
4. For beginner or ones who can’t invest large amounts, using DRIP’s through Transfer Agents allow for the investment of small amounts at no cost.
“By reinvesting dividends you get additional shares with small investments and don’t have the money sitting around.”
Agreed – a great benefit of Full DRIPs. There have been comments raised whereby this does not increase your return though.
“For beginner or ones who can’t invest large amounts, using DRIP’s through Transfer Agents allow for the investment of small amounts at no cost.”
This is what I did and I’m glad I did.
Nice work Mark. You definitely captured many reasons why dividend growth investing is so attractive.
Thanks!
Your example is very misleading. After the 30 years, the stock price is $133.50 and the annual dividend is $38.39 — hardly realistic. Typically, for mature companies, dividends and stock price grow a roughly the same annual rate. The Canadian banks broke this rule temporarily when they upped their dividend payout ratio, but having dividends grow faster than the stock price is necessarily temporary.
The annualized return for the non-reinvestment case is incorrect. The dividends are part of the stock’s return whether you reinvest them or not.
Good point Michael. I should have used something lower for the dividend growth rate, maybe something closer to 5%. I have updated the chart.
The way the calculator works – the annualized return for without and with dividend reinvestment is based on the value of the stock at the beginning of the first year (initial stock price multiplied by the initial number of shares) and the final value of the investment (Total Value). Are you saying if you don’t reinvest dividends at all, you get the same returns over 30 years in this example or in general?
In your new example where the dividend growth rate and the stock price growth rate are the same, the internal rate of return (IRR) is the same with and without reinvestment. The calculator treats the dividend cash as sitting and earning no interest over the entire 30 years. If you take into account the time value of money (as the IRR calculation does), the two returns will be the same.
So do you know what the logic is used with this TD calculator then?
http://www.td.com/investor-relations/ir-homepage/share-information/share-price-tools/investment-calculator.jsp
You get a much higher value with dividends reinvested.
Also, wouldn’t XIRR be a better calculation because returns (dividends are increased) over time?
Thanks.
I was able to figure out the incorrect logic from the examples you showed. There are many bad calculators out there.
You’re referring to the Excel functions called IRR() and XIRR(). These both calculate the same thing, the Internal Rate of Return (IRR). The difference is that IRR() assumes the cash flows are equally spaced in time (such as once per year), and XIRR() lets you specify the specific date of each cash flow. Both will give the same answer in this case.
The advantage of reinvesting dividends is not that it gives a higher return percentage; it’s that you’re investing more money.
Yes..not all calculators are created equal 🙂 The TD calculator also shows you’ve invested more money thanks to reinvested dividends. This is good for me anyhow!
“Why dividends?…They [companies] want to attract investors.”
Yes and no.
The investors have already come and gone in the primary market and the company has already utilized investor money.
In the secondary market, there is zero exchange of money between the stockholder and the company.
In reality, the stockholder is not investing in the company, but buying a financial instrument giving the owner a claim on a corporation’s future profits (bonds represent a truer investment in a company). The company may issue dividends to make these financial instruments more attractive, thus giving life to their stock price. A higher stock valuation can affect important situations and events for the company such as future financing, take-over bids, and insider payments.
Basically, they don’t really care what type of stock buyer they attract, just as long as their stock is in demand — it’s your want, not your money, which is valuable to the company.
I would say the stockholder is always directly or indirectly interested in the company – otherwise – they wouldn’t invest in it.
The investor definitely has a claim on the company’s future profits – that’s the entire point of being a shareholder. Maybe I am missing something SST?
Where we agree a higher stock valuation can affect important situations and events for the company but so can a lower stock value. I would argue for most savvy investors, a good company at a bad price is always in demand regardless if they pay dividends or not.
Indirectly, or, more succinctly — tangentially.
Exactly zero of the investor’s money goes to the company, thus they are not invested in the company but instead buy the company’s financial instruments (a bondholder is far more an investor in a company than a stockholder)*. That’s one of the dilemmas facing public companies — no one “owns” them (read some Robert Monks).
Yes, as we both stated, this financial instrument is a claim on the company’s future profits. I think of owning stocks akin to picking the best money manager, because that’s what you are really trying to do: figure out which CEO will best manage their company and thus increase the demand/value of the claim you own. Facing this, the appeal and strength of index funds/ETFs is obvious.
A dividend may come into play in both the manager’s and the stockholder’s decision (e.g. Apple Inc a couple years ago).
*(yes, I’m very much a stickler for correct financial definitions and verbiage, there’s no reason not to be.)
Yes, bondholders tend to take on less risk and therefore have a safer, more vested stake in any company. It’s a bit counter intuitive when you think about it – the definition of a shareholder I mean.
The battle will rage on forever, but I think the indexing appeal has to do with academics first, simplicity second. I don’t think it’s that difficult to own the top stocks in Canada – they are in the index year after year after year.
I think you can beat the index in Canada for a few reasons but namely Canada operates in a oligopoly-economy. The big companies operate with higher profit margins than any of the smaller stocks so it’s not really surprising that owning bank stocks, utility stocks, etc. over time can beat the average of the other Canadian companies.
The U.S. and international market is a different beast – so indexing is smart for most of that.
Oh, meant to add this article. I liked it.
http://www.wsj.com/articles/whats-the-best-way-for-retirees-to-invest-their-nest-egg-1426475052
SST, I agree. When we buy stocks on the secondary market we are really just putting our savings in a place where they they will likely grow better than some place else. We are not investing. Cullen Roche talks about that in this article.
http://www.pragcap.com/the-savings-portfolio-perspective/
Interesting words he uses to make his point:
“But when companies issue shares to raise money they’re simply issuing those shares so they can invest. And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production.”
Thanks for sharing the link. Looks like a book I should review and giveaway on the site.
I must say that when I buy shares on the secondary market I do not look at them any differently that buying IPO shares. I feel that I have shares in a company. That I own part of the company, not just a finacial instrument. Why I like shares in companies rather than doing index things is that my portfolio has recovered quicker than the TSX or CDZ from bear markets. (CDZ is sort of an index with stocks more like I own than the stocks in the whole TSX.) I wrote above this previously.
I did find Cullen Roche’s explanation very interesting though, even if I don’t fully agree. CDZ or XDV is close to what I own. VDY is similar as well.
Thanks for reading Susan – good to hear from you.
@Grant and @SST: I don’t find this attempt to narrow the definition of “invest” to be very useful. When I invest, my focus is on getting returns for myself. Whether my cash goes to a company in an IPO or to someone else in the secondary market makes little difference to me. I’ve bought shares with the hope of making a profit for myself in either case.
When I say that I’ve “invested in Google,” I don’t mean that I’ve given cash to Google so they can invest. It is not just novices who consider “investing in Google” and “buying Google shares” to mean the same thing. Virtually all financial professionals and researchers use the word “invest” in this way. I see no reason to make the meaning of “I invested in Google” depend on the effect it has on Google instead of the intended benefit for myself.
It’s true that my buying shares is different from a company spending money to increase production. But what they have in common is the entity deploying cash seeking returns. This is how the word “invest” has been used for a very long time. I think Cullen is wrong about this being an abuse of the word “investing”. However, the rest of his message about not flipping stocks is useful.
I liked Cullen’s perspective even if I don’t agree with it.
Like you Michael I invest to make a profit for myself. I use a more traditional definition for investing: an expectation of achieving a profit.
Flipping stocks is generally a very bad idea.
I’m a big fan of dividends and DRIPs as well. Easy compounding system. There are also some companies that offer a discount on the price of the new shares. I often use the leftover cash from the synthetic DRIPs to purchase ‘no-fee’ funds like a TD e-series when the market tanks on any particular day.
Correct. I didn’t cover that in this post, but there are lots of companies that offer DRIP discounts, primarily, to attract and retain investors.
The best Canadian site I know of for the DRIP and SPP list is this:
http://www.dripprimer.ca/canadiandriplist