When a stock you own pays dividends, you have two options: pocket the cash and use it as you would any other income, or reinvest it by purchasing additional shares of stock. Though having a little extra cash on hand may be appealing, reinvesting your dividends can really pay off in the long run.

Dividends: The Basics

Companies pay dividends to their shareholders to reward them for their investments and continued support. Dividends are taken from a company's retained earnings, which is the amount of cumulative profits that remains after accounting for all expenses and any reinvestment in the company's expansion. Though dividends can be issued in shares of stock, they are commonly issued as a cash payment.

Dividend Example

Dividends are issued to shareholders based on the number of shares outstanding. The greater the number of shares an investor owns, the larger the dividend payment she receives.

Assume company ABC has 4 million shares of common stock outstanding and issues a 30-cent dividend. In total, the ABC pays out $1.2 million in dividends. A shareholder who owns 50 shares receives $15, while an investor that owns 1,000 shares receives $300.

Dividend Reinvestment

Reinvesting your dividends simply means purchasing additional shares of stock with the money you receive. On most trading platforms, you can choose to have this done automatically on your behalf by simply checking a box. Proponents of this tactic highlight the fact that, by purchasing new shares of a stock that you know pays dividends, you can grow your investment at a much quicker rate than if you pocket your dividends and rely solely on capital gains to generate wealth.

In some cases, companies may provide a program for automatic dividend reinvestment that lets you purchase additional shares at a reduced price.

One of the chief benefits of dividend reinvestment lies in its ability to grow your wealth quietly, so that when you need to supplement your income, usually after retirement, you already have a stable stream of investment revenue at the ready.

Reinvestment Growth Example

Assume ABC pays an annual dividend of 3% per share, and its stock price increases by 10% each year. If you invest $10,000 when the stock price is just $25, you own 400 shares.

At the end of the first year, you receive a dividend payment of 3% * $10,000, or $300. The stock price increases to $27.50, so your reinvested dividend purchases an additional 10.9 shares. You cannot purchase fractional shares on the open market, but they are a common occurrence in dividend reinvestment plans.

At the end of the second year, you earn the 3% dividend on all 410.9 shares, yielding a total payment of $339. The stock price rises to $30.25, so reinvesting this dividend buys another 11.2 shares. You now own 422.12 shares valued at $12,769.

Three years after your initial investment, you receive a dividend of 3% * 12,769, or $383. Since the stock price has risen to $33.28, your dividend purchases another 11.51 shares.

At the end of just three years of stock ownership, your investment has grown from 400 to 433.63 shares. In addition, due to the stock's capital gains, the value of your investment has grown from $10,000 to $14,431. Because your reinvestment is automatic, you have not paid any commissions or other brokerage fees for the privilege of growing your investment.

Planning For The Future

If ABC's stock performs consistently and you continue reinvesting your dividends for another 17 years, you will own 666.94 shares valued at $115,231. If you have stopped working, you may choose to start taking your cash dividends to supplement your retirement income. Your 3% dividend is now worth $3,457 and will continue to increase as the value of your stock goes up.

If you had pocketed your dividend payments instead of reinvesting them, your original 400 shares would be worth only $67,275, plus $17,183 in dividends, for a total of $84,458. By simply reinvesting your dividends each year, you could increase your gains by 136%.

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