How To Reinvest Dividends for Higher Income and Returns

There are different ways to reinvest dividends. A simple way and a complex one. The simple way is to turn on the dividend reinvestment plan (DRIP) for companies you already own. The complex way is to pool your dividends and perhaps other available funds together and make a new purchase. Which is better?

Personally, I do a little bit of both. I DRIP, and I collect and invest. Out of the 37 stocks that I own, only six have DRIP turned on. I only turn on the DRIP for companies I believe are undervalued.

I can’t say which is better for you because I don’t know your goals. But I’ll discuss the benefits and the downside so you can decide which dividend reinvestment strategy better suits you.

DRIP: Keeping it simple

If you are the type of investor that wants to keep things simple, then, you can easily turn on the DRIP for all your holdings and be done with it. This is assuming that you hold quality dividend stalwarts in your portfolio. These dividend stocks generate consistent cash flows and have been growing dividends for years.

The US dividend stocks that come to mind include Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and Target Corporation (NYSE:TGT). They have increased dividends for at least 48 years in a row.

Here are their dividend growth rates in various periods:

Stock 1Yr DGR 3Yr DGR 5Yr DGR 10Yr DGR
Coca-Cola 8.9% 9.1% 8.3% 9.3%
J&J 6.6% 7% 7.4% 9.7%
Target 20.3% 20% 22.8% 20.3%

  • I like Coca-Cola’s consistency of increasing dividends at a rate of 8-9% a year.
  • Johnson & Johnson’s dividend growth rate seems to have slowed down recently, but the mega-trend of a growing aging population should improve the company’s profitability that could in turn translate to more income for shareholders.
  • Target’s 20% dividend growth rate has been amazing. However, it cannot keep up that kind of growth forever. From 2010 to 2013, its payout ratio increased from 23% to 28%, while its trailing twelve month (TTM) payout ratio has jumped to 46%. For comparison, Wal-Mart Stores, Inc.’s (NYSE:WMT) TTM payout ratio sits at 41%.

Reinvest Dividends by Collect and Invest

If you’re choosing to reinvest your dividends manually, you probably want higher returns, higher income, or both for your extra work. You maybe deciding which stock is the most undervalued at the moment. Investing in a better valuation stock, you’d expect higher returns than investing in a company with similar growth that is priced at higher valuation.

Out of the three companies above, I believe Johnson & Johnson and Target Corporation are at least fairly valued today, compared to Coca-Cola that’s fully valued at a P/E of 21.

Johnson & Johnson fundamental analysis graph
The F.A.S.T. graph shows that Johnson & Johnson is priced around a P/E of 16. That’s below its normal valuation of 16.9, but about a P/E of 15. So, Johnson & Johnson is in fair value range if not slightly undervalued, especially since that it’s awarded a S&P Credit Rating of AAA, the highest rating possible.

In Conclusion

No matter if you choose to DRIP, collect and investing, or a mix of both, reinvesting dividends in quality dividend stocks can only increase your return in the long-term. This is because you’re buying more shares each time you reinvest dividends.

Owning bigger pieces of quality businesses, your portfolio grows as the businesses grow in profitability and become more valuable. Your income will grow as well.

You get price appreciation and a steadily growing income over time. Reinvest dividends, and you’re letting compounding work in your favor.

I wrote a Seeking Alpha article regarding dividend reinvest that’s materially different from this article, using Kinder Morgan Inc (KMI) and Canadian Western Bank (TSX:CWB) as examples. It discusses checking company valuation, profitability, and sustainability of dividends that are preferably growing. If you’re interested, you can read it here: Dividend Reinvestment Can Be As Simple Or As Complex As You Make It

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Disclosure: At the time of writing, I am long KO, KMI, and TSX:CWB.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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