Dividend Reinvestment is one of the most important concepts when it comes to investing. It is a way of owning more shares or units in a fund without putting your hand in your pocket for more cash beyond the original investment. It is a way of getting shares for free.
To see how dividend re-investment works, take a look at the following. Say you own£10,000 worth of shares in Company A. This pays a 10% dividend each year, equal to £1,00 on your £10,000 investment. If you reinvest that £1000 in more Company A shares, you will have an investment worth £11,000. Fast forward one year and your 10% yield on the bigger-sized investment equals dividends worth £1,100 – so £11 more than you got last time. If you reinvest that £1,100 in more Company A shares, your overall pot will be worth £12,100. A 10% yield a year later on that pot equates to £1,200. That’s £200 extra money from dividends versus what you received two years earlier. That is £200 in cold hard cash you receive completely free. You can see how your dividend keeps getting bigger each year, so too the size of your overall investment – and that’s without assuming any share price appreciation. If you keep reinvesting your dividends into buying more shares, you can really end up boosting the value of your portfolio.
When you reinvest your dividends, you really harness the power of compounding. Dividend reinvestment allows you to build up your portfolio without having to pour additional money into your portfolio.
Companies That Are Worth Reinvesting Dividends In
When it comes to looking into companies that you wan’t to reinvest dividends in, you need to realise that all companies are not created equal. The best candidates for reinvestments are those with a long history of paying dividends, a solid dividend growth rate and dividend payout ratio that is not too high.
I see many people that tend to ignore the dividend payout ratio but I do believe that it is the most important of the above three measures. A reasonable payout ratio is an indication that a company has the ability to grow the dividend and provide plenty of income that you can reinvest. When I look at the dividend payout ratio, I need to ensure that a company does not pay out more than 70% of its free cash flow. This ensures that the dividend is well covered and the company retains some cash to reinvest in the business in order to grow the dividend for years to come.
Personally, I believe that companies within the consumer staple industries make the best candidates for a dividend reinvest plan. Companies like Unilever, Nestle, Johnson & Johnson and Colgate Palmolive which have prodigious amounts of cash flow and a great track record of paying out dividends make exemplary candidates for perpetual reinvestment. You need to remember that every time you reinvest a dividend back into the company that paid it, you are escalating your commitment to that company. That is why it is imperative to get the company you want to keep re-investing money in right. And for me, there are no better better candidates than the four mentioned above.