The compounding from dividends can be an incredible force. I have a dividend stock I’ve held and reinvested dividends in for over 5 years. I feel this stock is a great dividend reinvestment plan example especially to show how it literally multiples your total return.
A dividend reinvestment plan, or DRIP, is one where any dividends received are automatically reinvested in that same stock.
It’s a fantastic plan because it’s:
- Habit forming
- A compounding effect
- Creates returns which multiply
I don’t use that “multiply” word lightly. It literally does multiply.
After all, that’s the power of compound interest. Compound interest is exponential, which means that returns multiply on themselves. A powerful force over a long enough period—I’ll show you exactly how with this dividend reinvestment plan example.
Before we dive into the exact company I purchased over 5 years ago and have used the DRIP with, check out these charts. Notice the difference between a stock with reinvested dividends and one without:
You could repeat these simple charts yourself, as I’m using historical averages for the following:
- Annual return = 10%
- Dividend yield = 3.26%
Here’s if we assumed that the company grew its dividend 5% per year, adding a third layer of extra compounding:
These DRIP examples should be enough to seal the door on this topic altogether, but I know we all (myself included) want to see the real deal.
This one will just be simple math, and I’ll be taking screenshots from my real brokerage account (the one I use for the Real Money Portfolio of The Sather Research eLetter).
There’s this technology business which was trading at a fantastic valuation back in 2016 which I purchased: Cisco Systems ($CSCO).
Here’s the buy order, and some dividends I received from it that year:
You can see that yes, this was in the old days back when you had to pay a small commission to buy and sell stocks. Buying fractions of shares wasn’t even heard of.
Also notice how small those initial dividends were, more on this later…
Now, let’s get an update on the position as of today. I want to emphasize I did not make any additional purchases of the company since, other than the shares from the dividend reinvestment plan.
I crossed out some current positions, because these are buy recommendations for paid subscribers for The Sather Research eLetter.
Another weird quirk is that the “Total G/L” is different than my real gain/loss because Ally Invest adds dividend reinvestments to Cost Basis. I’d argue this should not be the case because my dividends are “free”; maybe it’s for tax purposes but this is a Roth IRA.
The bottom line is that I spent $140.91 to buy 6 shares of Cisco in 2016, and did not buy any additional shares. The dividend reinvestment plan has added an additional 1.117 shares. That’s basically 18.6% of my initial investment added strictly from DRIP.
Without DRIP, my return on 6 shares would be 110.5%. Not a bad return over 5 years, but significantly less than the 180.2% total return I have because of the dividend reinvestment plan (more on that later).
Needless to say, these extra shares from the dividend reinvestment plan have been a great boost to total return.
You can also see that the stock now trades at $55.47. That means that the extra shares from DRIP alone are currently worth $61.96.
Just those extra shares are already worth almost half of my initial investment.
Another great example of the great things that can happen from DRIP in a good company that you hold for the long term. It’s not unreasonable to think that in another 5 years, the extra shares from a continuation of DRIP could be worth more than my initial investment itself—almost as if the investment I made was “free”.
How DRIP Makes Total Return Multiply (Example)
What I wanted to highlight for this dividend reinvestment plan example is how total return is multiplied from this factor.
First, let’s calculate total return, as the current total value of the investment versus the initial value.
My Cisco shares are currently worth $394.78, and remember I paid $140.91, and so my total return over these 5 years is 180.2%.
Let’s say that Cisco’s stock were to jump +10% tomorrow. A lofty hope, but bear with me just for this example.
That would push the stock price from its current $55.47 to $61.02.
But my return would not add +10% from 180% to 190%. It would actually be much higher.
Using today’s current shares:
- 7.117 shares
- $61.02 price
- $434.28 total value
Now let’s compare our new total value versus the amount I paid initially ($140.91):
Total Return = ($434.28/$140.91) – 1
Total Return = 208.2%
You can see how total return jumped from 180.2% to 208.2% on a +10% jump of the stock.
That’s the power of compound interest, and DRIP! I hope it’s obvious now why I say how a good dividend reinvestment plan can cause return to multiply!
A Few Caveats on Total Return
Now, also understand that this knife cuts both ways. If the stock were to drop 10%, the total return would also drop by a factor greater than 10%.
But if you are interested in holding stocks for the long term, and you are confident that your companies will continue to grow, then this drop would likely be temporary.
If you are tracking your portfolio’s performance from month-to-month, you won’t see this multiplicative effect to total return.
This is because your portfolio has already factored this multiplicative effect each time you measure it. Over the long run, if you were calculating a final value from an initial value (what you put in), you would see the multiplicative effect.
Lessons from this Dividend Reinvestment Plan Example
The longer that you hold a stock, the greater the multiplicative effect you saw here today.
It really lends credence to the idea that there’s a huge advantage to the investor who can simply sit on their investments and wait for each to compound.
Since returns from DRIP multiply like this, it’s not unreasonable to think that what you consider a “losing position” can’t rebound. An underperformer could reverse direction and “catch up” quickly, through the power of compounding.
As you accumulate more dividends on a position, the Total Value of the position will swing more violently. It will have a much greater value than the initial investment you put in. Meaning your Total Return will swing much higher and lower.
To see that on the upside will be a very powerful thing. It’s simply due to the way Total Return is calculated and the effect of the dividend reinvestment plan.
That said, we can’t use this effect as an “end-all, be-all” excuse for blindly holding on to terrible investments.
The compounding effect of a stock that eventually goes bankrupt is zero.
And opportunity cost of underperforming positions is a real problem. Especially when you can get much better compounding elsewhere.
I think the best plan is to be somewhere in the middle of this idea. Be patient enough to let underperformance ride out for longer than you might think, but ruthless in identifying when a company’s fortunes have really changed.
The power of a dividend reinvestment plan is really the power of compound interest disguised. But its multiplicative effect is real.
As you apply this to your investing decisions (or not), think about how it aligns with your goals.
For example, is calculating Total Return important to you? Or is calculating incremental improvements in portfolio return more important (in which case you won’t see multiplication in the results of the formula)?
Is having a nice looking Total Return figure more important to you? Or is having the highest possible compound interest more important?
Just remember—the longer the holding period, the greater the multiplicative effect of DRIP… that’s compound interest.