Dividend reinvestment is a systematic method of accumulating shares of a company that pays a dividend. Some investors use dividend reinvestment as part of a long term buy and hold investment program.
The main advantage of reinvesting your dividends is that you are able to make use of the power of compounding in your favor. By using the dividend income to purchase more shares, an investor is able to accumulate more shares of a company.
Another reason for reinvesting dividends is that one could cost average their dividend income into more shares by spreading their purchases over a period of time, which also decreases risk.
Important terms related to dividends
Dividend Yield
It is calculated by dividing the Dividends per Share with the Share Price. Income investors will tend to go for stocks with high dividend yields.
But a high dividend yield may also indicate a depressed price.
The important indication of dividend power is not so much a high dividend yield but high company quality, which you can discover through its history of dividends, which should increase over time.
Dividend payout
This is the percentage of earnings paid to shareholders in dividends. This is calculated by dividing the Dividends per Share by the Earnings per Share
More mature companies tend to have a higher payout ratio. Meanwhile growth companies tend to have lower dividend payouts as the management believes that shareholders will be able to achieve greater returns if the majority of the company’s earnings are ploughed back into the business.
Management decides what percentage of earnings will be paid out to shareholders, and then puts the remaining profits back into the company.
Dividend Trap
A company may have an inviting dividend yield but the business might be on its way down. Is the company expected to maintain the Dividends Per Share for the next financial period? An investor should analyse the other fundamentals of the company Since dividends are paid from cash, the company should have some previous consistency of earnings growth. The company should not recently have taken out a huge debt which would bring cash flow problems to the business.
In conclusion, investors should know that reinvesting dividends provides a tremendous opportunity for growth of wealth over time.
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