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Don't lose money unnecessarily. Why is dividend reinvestment important?

Mart Poom
25. 5. 2023
6 min read

Dividends are a nice part of investing. You can use them as passive income or use their power to reinvest them to increase your total return. And that power is truly enormous!

Everyone can probably think of the fact that by reinvesting dividends, we increase our total return in the first place. But this strategy has several other advantages.

Reinvesting dividends brings a number of positives, such as capital accumulation, the ability to achieve a higher total return, lower capital gains taxes and inflation protection. In the following article, we will therefore focus on these aspects and show how dividend reinvestment can affect the long-term return on equity investments.

  • Reinvestment enables capital accumulation. When an investor reinvests dividends, he receives additional shares in the company. This helps him to accumulate capital. The more shares a person owns, the greater his share of the company's profits.

Imagine you invest $10,000 in shares of a company that pays a 5% dividend, or $500 a year. If you only collect dividends, you will receive a total of $5,000 in dividends in 10 years and still own the stock for the original $10,000.

However, if you reinvest every dividend paid back into the company's stock, your ownership of the company will grow. So let's add up the dividends paid over ten years:

Year 1: $500 dividend = reinvested in additional shares
Year 2: $525 (reinvested amount from year 1 x dividend rate)
etc.

By year ten, you've already reinvested over $750. This means that the proceeds of the total $5,000 dividend paid have been reinvested back into the company. So the firm paid you $5,000 in dividends, but your share of the firm has also increased because you acquired more than $5,000 worth of new stock.

Thus, thanks to the reinvestment, you not only have $5,000 cash from the dividend, but also stock worth more than your original $10,000 investment. So by reinvesting, you have accumulated more capital. A higher share of the company will also provide you with higher future dividends.

Of course, we're talking about an example where you want to accumulate money, not "enjoy" it. That is, to take it out and use it for other purposes. This is also a perfectly legitimate approach.

  • It allows for a higher total return. In addition to the dividend payment, investors also get a capital gain when the share price rises. By reinvesting dividends, investors can increase their share of this capital gain.
  • It supports the growth of the company. When investors reinvest dividends, the company receives additional cash that it can use to grow the business, expand or make acquisitions. This can lead to higher future dividends and stock price.

Reinvesting dividends supports the growth of the company by providing additional cash. When investors reinvest dividends back into the company, even if the company does not receive a cash dividend, it has more capital available. The company can use these funds for various purposes such as expanding production, opening new branches, acquisitions, or product development. This will enable it to grow the business, increase sales and profits.

Thus, the firm can maximize the use of its growth potential. If its strategy is successful, this will be reflected in higher appreciation of the investment in the form of an increase in the share price. Higher profits will then allow the company to pay a higher dividend to investors again. This could create a virtuous cycle of growth.

Reinvested dividends represent a relatively cheap source of finance for the company, which does not have to pay interest on it as with loans. This allows the firm to use its resources more efficiently for pro-growth strategies.

  • It allows them to benefit from lower taxes. In some countries, capital gains are taxed at a lower rate than dividends. Reinvesting can take advantage of this tax advantage.

In some countries, capital gains are taxed at a lower rate than dividends. Reinvesting dividends can therefore take advantage of this tax advantage because the dividend is reinvested in more shares which then generate capital gains. This is often taxed at a lower rate.

The reinvested dividend increases the initial purchase price of the shares for tax purposes. Therefore, the investor has a higher tax basis for calculating the capital gain when the shares are sold. The capital gain that will be subject to tax is therefore lower.

Reinvestment of the dividend increases the investor's cost of the stock. If the investor sells only a portion of his shares, his capital gains tax basis will be reduced proportionately. The longer investment horizon for dividend reinvestment can also mean a lower tax rate because investors typically pay lower taxes on long-term capital gains - the timing test and the exemption.

  • Provides protection against inflation. Reinvesting dividends can maintain the real value of your capital because stocks can increase in value faster than inflation.

Reinvesting dividends can provide inflation protection for several reasons.

  1. Capital growth. Reinvesting dividends increases an investor's stake in the company and potentially their profits. This allows the real value of the investment to be maintained.
  2. Company growth. As I mentioned earlier - The firm reinvests dividends into its growth, which should exceed the rate of inflation. This should translate into share price growth that offsets the effects of inflation.
  3. Capital Gain. If the stock price grows faster than inflation, this generates a real capital gain. By reinvesting the dividend, the investor increases his share of this gain.
  4. Longer investment horizon. The longer an investor holds a stock, the more chance he has to capitalize on the company's potential to outperform inflation.

Reinvestment therefore allows the rate at which the investor accumulates capital in the firm to accelerate. If the firm generates appreciation above inflation, the investment maintains its real value. However, it is not a guarantee - the firm must be able to generate value above inflation.

So, in summary, reinvestment allows the investor to accelerate capital growth, achieve a higher total return, support the company's growth, take advantage of lower taxes, and better protect against inflation. Therefore, it is very beneficial for investors.

Disclaimer: This is in no way an investment recommendation. It is purely my summary and analysis based on data from the internet and other sources. Investing in the financial markets is risky and everyone should invest based on their own decisions. I am just an amateur sharing my opinions.

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