Two main benefits to stock ownership motivate investors: firstly, stockholders own a percentage of the company, which should theoretically increase in value as the company’s value increases.
Secondly, as a partial owner of a company, stockholders have a right to a portion of the profits that those companies earn. Several companies distribute those profits as dividends, which is calculated as a percentage of the value of a stock. See the table below for a few of the most popular dividend-paying stocks on the market:
| Company Name | Ticker | Stock Price (as of 8/31/2012) | Dividend Yield (% annually) |
| AT&T | T | 36.67 | 4.8 |
| Reynolds American | RAI | 46.23 | 5.11 |
| PepsiCo | PEP | 72.35 | 2.97 |
| Coca-Cola | KO | 37.39 | 2.73 |
| Johnson & Johnson | JNJ | 67.31 | 3.63 |
What do these numbers mean? Simply put, every share of stock entitles the shareholder to a certain cash payout that is set by the company at regular intervals (dividend payouts can and do go up or down).
An investor who owns one share of AT&T stock, for example, will get an annual cash payment of $1.76 per year (36.67x.048). Those payments are usually made in four quarterly payments–in this case, each stockholder gets 44 cents per share four times per year.
Dividends are an extremely attractive benefit to stock ownership, because it is effectively passive income–investors get this money deposited into their accounts without doing anything but holding on to their stocks.
While this is an extremely valuable side to investing, those dividends are much more valuable if they are reinvested into the company. Such dividend reinvestments are possible through something called a “DRIP”, which stands for “Dividend Reinvestment Plan”. DRIPs are offered by dividend-paying companies to their shareholders, and they allow dividends to be automatically reinvested into shares or fractions of shares of that company.
When investors enroll in a DRIP, they no longer receive dividends in the form of cash–instead, the investors will see the amount of shares they own increase proportional to the dividends they are paid out.
An Example of Exponential Growth
For example, let’s say someone owns 100 shares of AT&T, which would cost $3,667 to acquire today (we’ll ignore taxes and fees for now). That investor is entitled to $176.016 per year in dividends, which is worth an extra 4.8 shares (176.016÷36.67). At the end of the first year, the investor will now have 104.8 shares, which is now worth $184.448 in yearly dividend payouts. By reinvesting dividends this way, investors can compound the value of their dividends and earn future dividends from those dividend payouts.
Let’s imagine our investor keeps those 100 shares for 30 years and AT&T stock never goes up or down and the company keeps paying out the same dividend yield. At the end of 30 years, the investor’s AT&T stock will yield $727.84 in annual dividend payouts. In other words, the passive income from the initial $3,667 investment has more than quadrupled without the investor doing anything besides buying 100 shares once thirty years ago. What’s more, the investor will have a little over 418 shares that will be worth $15,345.19.
In reality, that initial investment will probably be worth substantially more. For this example, I assumed that AT&T’s dividend would not go up, but it has gone up a lot in the past and is very likely to go up in the future. In the past 10 years alone, AT&T’s dividend rose by 62.96%. If it raises at that pace for the next 30 years, that initial 100 shares will yield $16,029.90 and the shares will be worth $180,178.92–assuming the shares are still priced at $36.67.
Dividend reinvestment is powerful.
Fees, Minimums, and Tax Issues
Some DRIPs involve a fee to register, although there are several no-fee options offered by some brokers. Usually, brokerages will include a minimum investment to register for a DRIP, although minimums sometimes go as low as $500.
DRIPs also involve some tax complications that involve a bit of paperwork and tracking. Whenever those shares are sold, capital gains taxes must be paid on the profit made from the initial share price. If the stock price never goes up, this isn’t a problem, but if the share price appreciates over the period of reinvestment–as it probably will–shareholders need to pay tax on the profit made between the cost of the shares purchased and the amount the shares sell at.
This is very difficult to figure out with DRIPs, because investors are constantly buying shares and fractions of shares every time dividends are paid out. Fortunately, brokerages and firms offering DRIPs will calculate these for investors and detail their cost and sell price per share for every share owned. Still, the capital gain tax burden should not be ignored with DRIPs, even if the timeline for such a program is long.