I have seen some investment gurus always mention how good a dividend re-investment strategy could be. Recently I have been following some dividend stock blogs and am a dividend investor myself.
Always interested in mathematics I was curious how the numbers add up and what the compound rate of return would be under different scenarios. Let us start with a simple example:
Investment capital : $1000
Stock Price: $1
Yield : 5%
Dividend growth rate: 5%
Time span: 5 years.
I used the calculator here.
Total value of this portfolio without dividend reinvested would be $1580.88 and with dividend reinvested would be around $1,648.38. The net yield is 9.51 vs 10.51 respectively.
Lets play around with some numbers. Increasing the timespan to 20 years which is typically realistic with dividend or long term investors we can see the difference: 7.4% vs 10.5%.
If the stock price remains the same for 20 years with no variation one can get 5.16 vs 8.35 % for reinvested dividends.
Now if the stock price is 10% down annually in a timespan of 5 years then the ROI for the reinvested dividends is -3.43 which is lesser than -3.16. In my example if I set the stock price move to 5% down annually for 10 years then the dividend reinvestment scheme still proves better.
Overall I feel like a dividend investor should have an exit strategy just like any other investor. If the fundamentals for the company look good then reinvesting in a downtrend might be risky but worth it.
Before I forget, there is a definite tax advantage to these reinvested dividends which is a separate topic itself. But the flip side is that calculating cost basis for re-invested dividends could be time consuming.
What is your re-investment strategy? From most of the examples above it seems that re-investment does make sense unless ofcourse you want free cash flow.