Investing

DRIP Baby, DRIP

DRIP

Becoming a parent is a life altering event that comes with its joys and often trials and tribulations. As they hold their bundle of joy and admire the little miracle, rarely are young parents thinking beyond stocking up on more diapers or getting a full night of uninterrupted sleep. But this is precisely the time they should be thinking about getting a life insurance policy should any misfortune befall the breadwinners of the young family or starting a 529 plan to save for the kid’s education in a tax efficient instrument.

Another strategy that can supercharge the young family’s investment returns is a dividend reinvestment plan or a DRIP. As they grab for another bottle of Johnsons & Johnsons baby powder or consider Aflac (the company with those weird duck commercials) for life insurance they should also think about how these two companies offer a no cost DRIP program. Companies provide returns to their investors in several ways including through stock appreciation, stock buybacks or by paying a dividend at a regular interval (usually quarterly). Some of these companies also allow investors to set up a DRIP plan that will automatically reinvest the dividend paid into additional shares of the same company without any trading fees.

For example let us consider Johnson & Johnson (NYSE: JNJ) which currently trades for $150 and change. They pay a dividend of a little over $4 per year paid out at about $1 per quarter. If you own 100 shares of Johnson & Johnson, you will get roughly $400 per year or about $100 each quarter. If you participate in Johnson & Johnson’s dividend reinvestment plan, they will automatically buy an additional 2.67 shares of Johnson & Johnson for you that year using your dividend payout. This assumes the price of the stock has not changed since you bought it.

The next year you will likely receive a dividend on 102.67 shares instead of the original 100 shares and if Johnson & Johnson increases its dividend by 6% (it has increased its dividend by 6.32% in each of the last five years), your dividend payment could be $4.24 per share or $435 for 102.67 shares. Depending on Johnson & Johnson’s price at the time of the dividend payouts, you could end up a few more shares. So after year 2, you might hypothetically have 105 shares. If Johnson & Johnson continues to do well as a company and wants to share more of its profits with its shareholders, they might increase their dividend again by 6% and the dividend payout could now be $4.49 per share. Your payout would most likely be around $472 for 105 shares.

In just three years your dividend potentially increased from $400 to $472. This is the power of compounding supercharged through DRIP plans. But wait, it gets better. Much better.

We were discussing setting up a DRIP plan with a specific company, which is the way investors had to do it in the past. There were very few companies that offered this option and so your choices were limited. You also had the additional burden of keeping track of all these individual DRIP plans.

Brokers like Fidelity and TD Ameritrade (currently in the process of merging with Charles Schwab) now allow you to DRIP any dividend paying stock by buying fractional shares of the company every time it pays a dividend at no additional cost to you. Fidelity does this by default but you have to turn this feature on in TD Ameritrade. I am sure most other large brokers also offer this option.

When investors think about dividends they think in terms of yield or what their dividend returns will be considering the size of the investment. This is akin to the interest paid on a loan or the interest you receive in a savings account. If you buy a stock for $150 and it pays a dividend of $4 per year, the dividend yield works out to 2.67% ($4 divided by $150). If you buy a stock for just $100 and it pays a dividend of $4 per year, the yield is 4%. The 500 largest companies in the United States represented by the S&P 500 index have a yield of 2% at the moment.

There are stocks and other instruments that can yield significantly more than the 2% you would get from buying the S&P 500 ETF (NYSE: SPY). If you put one of those on a DRIP plan, the supercharged power of compounding can really add up. Keep in mind that a higher yield could mean higher risk or that you are probably going to give up capital appreciation of the underlying stock or ETF. The icing on the cake is that many companies increase their dividend payout each year to share their growing profits with their shareholders as discussed in the Johnson & Johnson case above. There are companies that have continuously increased their dividends for decades and they are referred to as Dividend Aristocrats.

Just like living organisms, companies grow, thrive and eventually go into deep decline. Sometimes they recover from this decline by transforming their business and at other times they die. Just like the Dividend Aristocrats that have been increasing their dividends for 25 years, there are companies that run into trouble and cut their dividends to zero or just a few pennies. General Motors (NYSE: GM) and General Electric (GE) are two companies that have cut their dividends recently.

I decided to model two different scenarios for Johnson & Johnson’s stock with one scenario not reinvesting the dividend and the second scenario using a DRIP strategy. Assuming Johnson & Johnson continues to increase its dividend at a 6% pace for the next ten years (a very big assumption considering the current COVID-19 crisis) and the stock sees its price go up by 5% a year, a $10,000 investment in the company would become $19,053 in ten years including dividends for a 91% total return. Not bad considering it is an investment in a mature but potentially stable company.

The same $10,000 investment would have grown to $23,682 in ten years with a DRIP plan for a return of 137% return. That is a difference of 46% without lifting a finger. Obviously the first scenario assumes you did not do anything with all the dividends and just let them sit in cash yielding nothing. In real world scenarios, the difference could be larger if your dividend payments were not redeployed into fruitful investments or smaller if the dividends were invested in another company that did better than Johnson & Johnson.

Please keep in mind that if the dividends are paid in a taxable account, you will be responsible for taxes on those dividends depending on your tax bracket. If you are not already doing it, DRIP away my friends. It could have a huge impact on your financial outcome in the long run.

Disclaimer: This article is only for education purposes and should not be considered investment advice. Please consult with your financial advisor and accountant before making any investment decisions.

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