The power of dividend reinvesting

The power of dividend paying stocks simply cannot be understated. This is money that is paid out of a listed company’s profits to shareholders on a per share basis. This means that the more shares you own, a higher proportion of the dividend you are entitled to. Although they may appear small and insignificant in the first instance, in the long run they can dramatically improve total returns on a portfolio.

 

Online broker TD Waterhouse recently published an article demonstrating this effect. It compares the results of the FTSE all share index, the FTSE all share index with dividend reinvestment, and the index of the 50 FTSE all share companies with the highest dividend yields. The timeline is from 31st May 2011 to 31st May 2016, and the results are as follows:

 

  • The FTSE all share index gained 9.9% during that time, equating to an annualized return of a meager 1.91%.
  • The index with dividend reinvestment taken into account gained a far greater return of 31.2%. This equates to a respectable annualized return of 5.58%.
  • Finally the index with the 50 highest dividend yielders returned an even more impressive 43.2%, equating an annualized return of an inflation-busting 7.45%!

 

A visualization of these charts is given in the table below.

ftse-allshare-reinvesting-dividends

Let’s take a specific company as an example, say Legal and General, which is a stable FTSE100 company that has a progressive dividend policy. Since 1998, the average annual dividend growth rate is 9.5%.

Assuming £500 is invested, the annual growth of the share price is around 4%, and the dividend growth of 9.5% continues over a period of 20 years, the dividend income per year is tabulated below.

 

Year Dividends paid (£)
1 £31.81
2 £38.45
3 £45.03
4 £53.07
5 £62.97
6 £75.26
7 £90.66
8 £110.16
9 £135.12
10 £167.41
11 £209.71
12 £265.84
13 £341.36
14 £444.46
15 £587.44
16 £789.07
17 £1,078.51
18 £1,501.97
19 £2,134.16
20 £3,098.54

 

As you can see, under the assumptions made, at the start you’re only paid a small amount of £31.81. However if you hold the shares for 20 years, you can earn a staggering £3,098.54! Not bad for a one off decision to chuck in 500 quid and forget about it!

 

What this comes to show is that dividends are a must for investors seeking to pursue wealth in the long run, as they can play a vital part in fulfilling your financial goals in the future. The power of dividend reinvestment simply cannot be overstated.

 

However, there are a few things to consider before choosing which dividend stocks to invest in.

 

First of all, the dividend yield in isolation can be misleading, especially if it’s based on the previous year’s reports and the company experiences financial difficulty since then. This can seriously hamper your financial results, due to a depressed or stopped dividend, and a likely associated share price collapse.

 

Next, take a look at the company’s dividend cover. This measure simply states how many times the dividend paid out is covered by the firm’s after-tax net profits. As a rule of thumb, a number greater than 1.5 generally indicates the dividends are sustainable, whereas vice versa, the dividends are vulnerable to reduction in years that prove to be less profitable. The higher the cover, the safer and more sustainable the dividend income stream is.

 

Finally take a look at the past 3-5 years of the dividend growth for a particular company. This will be a useful tool in comparing dividend payers with similar yields, in terms of helping you to decide which company has the best potential for long term returns due to enhanced dividend increases.

 

I hope the above has proved useful. Let me know your thoughts/questions in the comments below and I’ll see you again soon in the next article.

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