When Reinvesting Dividends Can Do You Wrong
Reinvesting dividends paid on shares of common stock frequently represents an outstanding way in which to benefit from the long-term compounding effect of common stock ownership. Investing website The Motley Fool calculated that the value of $10,000 invested in the S&P 500 in 1960 – with dividends reinvested through 2021– would have compounded to a cool $4.95 million. The value of the reinvested dividends accounted for $4.16 million, or 84%, of the gain, while simple share price appreciation made up only $795,800 of the increase.
Depending on reinvested dividends from single stocks, though, may present unforeseen risks for investors. Consider a hypothetical example in which an investor initially pays $10 per share for 2,500 shares of common stock in a company that pays an attractive 8% yield. The investor chooses to reinvest their dividend proceeds back into more common shares of stock in the company. In the first year these dividend reinvestments result in an additional $23, or 0.1% of dividend yield, as compared to not reinvesting the dividends.
All initially appears well with respect to dividend income and rate in Year 1 of our hypothetical example. However, negative dynamics in asset markets begin to erode the underlying value of the $25,000 initial investment made in our example. Possibly interest rates increased, reducing the relative attraction of an 8% dividend yield as compared to other investments. Or, maybe the company lost a key management member, incurred a lawsuit, or experienced cost overruns on a large project. Potentially, management adopted too aggressive of a dividend policy and, as a result, its cost of capital in the higher interest rate environment negatively altered its investment proposition as it needed more capital from outside sources to fund its operations.
Whatever: the company in our example sees its shares decline 5% annually over a five-year period. Management, however, continued to believe that a relatively high dividend policy attracted shareholders despite ongoing share-price declines for the company; they ratcheted up the original $0.80 per share, 8% dividend rate by 2% annually. As shown in the table below, the combination of declining share price and escalating dividend rate actually enhanced the dividend rate for the company to ~8.5% over the five-year period. Also, the quarterly dividend payment to the investor grew considerably – $133, or 26.6%, – over the five-year period. In year 5 of our example the investor receives an estimated $2,497 in dividends versus $2,023 of estimated Year 1 dividend payments. Finally, the overall value of the investment grew to $29,503 from our initial $25,000 stake, an increase of 17.1%.
All of that may appear not horrible at first glance: growing dividend payments and a positive total return, sign me up! The catch, though, is that the investor paid an additional $11,251 in reinvested dividends in order to achieve that $29,503 Year 5 value. In effect, they lost $6,747 as the share price in our hypothetical example moved from $10 per share to $7.78. This share price decline may appear relatively benign as compared to the moves for many stocks in 2022, but the actual compounded annual rate of return for our investor calculates to a measly 3.37%. Even with the S&P 500’s abysmal 2022 total return, this rate pales in comparison to that index’s 9.5% five-year compounded average annual growth rate from 2018 to 2022.
Also, this 3.37% annual rate of return is a far cry from the anticipated 8% rate implied by the dividend and only slightly better than one-half the 6.5% rate of inflation posted in 2022. In purchasing power, the investor would find themself noticeably worse off. The rate of annual dividend growth would need to leap to 17.5%, implying a Year 5 dividend yield of 14.3%, for the value of this investment to keep pace with 2022’s rate of inflation. Similarly, our investor would keep pace with a 6.5% rate of inflation were the shares in our example to only decline 2% annually, all other factors remaining equal.
| Hypothetical Value of Reinvested Dividends with Declining Share Price | ||||||||
| Quarter | Qtr Dividend Rate | Qtr Dividend Amount | Annual Dividend | Dividend | Share Price | New Shares | Value of Investment | Annual Dividend Rate |
| 1Q01 | 2.00% | $0.20 | $0.80 | $500 | $9.88 | 2,551 | $25,188 | |
| 2Q01 | 2.00% | $0.20 | $0.80 | $504 | $9.75 | 2,602 | $25,376 | |
| 3Q01 | 2.00% | $0.20 | $0.80 | $508 | $9.63 | 2,655 | $25,567 | |
| 4Q01 | 2.00% | $0.20 | $0.80 | $511 | $9.51 | 2,709 | $25,758 | 7.85% |
| 1Q02 | 2.04% | $0.20 | $0.82 | $525 | $9.39 | 2,765 | $25,962 | |
| 2Q02 | 2.04% | $0.20 | $0.82 | $530 | $9.27 | 2,822 | $26,167 | |
| 3Q02 | 2.04% | $0.20 | $0.82 | $534 | $9.16 | 2,880 | $26,374 | |
| 4Q02 | 2.04% | $0.20 | $0.82 | $538 | $9.04 | 2,940 | $26,582 | 8.00% |
| 1Q03 | 2.08% | $0.21 | $0.83 | $553 | $8.93 | 3,002 | $26,803 | |
| 2Q03 | 2.08% | $0.21 | $0.83 | $558 | $8.82 | 3,065 | $27,026 | |
| 3Q03 | 2.08% | $0.21 | $0.83 | $562 | $8.71 | 3,129 | $27,250 | |
| 4Q03 | 2.08% | $0.21 | $0.83 | $567 | $8.60 | 3,195 | $27,477 | 8.15% |
| 1Q04 | 2.12% | $0.21 | $0.85 | $583 | $8.49 | 3,264 | $27,716 | |
| 2Q04 | 2.12% | $0.21 | $0.85 | $588 | $8.39 | 3,334 | $27,958 | |
| 3Q04 | 2.12% | $0.21 | $0.85 | $593 | $8.28 | 3,406 | $28,202 | |
| 4Q04 | 2.12% | $0.21 | $0.85 | $599 | $8.18 | 3,479 | $28,448 | 8.31% |
| 1Q05 | 2.16% | $0.22 | $0.87 | $616 | $8.07 | 3,555 | $28,708 | |
| 2Q05 | 2.16% | $0.22 | $0.87 | $621 | $7.97 | 3,633 | $28,971 | |
| 3Q05 | 2.16% | $0.22 | $0.87 | $627 | $7.87 | 3,713 | $29,236 | |
| 4Q05 | 2.16% | $0.22 | $0.87 | $633 | $7.78 | 3,794 | $29,503 | 8.46% |