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.
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.
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?