Dividend stocks are equity investments that pay cash to investors on a regular basis. Investors often have different goals when buying dividend stocks, but each investor must decide whether to reinvest the dividend or take the cash.
Valuing a Dividend Stock
The dividend discount model says that the price of a dividend stock should equal the value of next year's dividend divided by the expected dividend growth rate. There are complexities for stocks that assume a constant dividend or continual growth, but before investing in any stock it is important to understand the intrinsic value.
Dividend Growth vs. Equity Growth
Some investors prefer dividend stocks because they pay out a nearly guaranteed cash flow
for the foreseeable future. Walmart is currently paying a dividend of 2.5% per year. Even if the stock only increases 2.5% in price, you still get a 5% return.
Companies like Berkshire Hathaway are famous for their non-dividend policy. Warren Buffet, the famous investor in charge of Berkshire Hathaway, says he can give investors a better return if he uses the cash rather than pay it back. He has been spot on, growing book value an average of 19.7% per year compared to 9.4% on average for the S&P 500.
Determine Your Goals
Are you looking to retire soon, or are you looking to save for retirement? Are you trying to build wealth or create a cash stream? Those are the types of questions you have to answer when deciding what to do with a dividend.
For investors in retirement, a cash flow is clearly the most important goal. If you can create a steady income stream without selling your capital, you are in great shape. If an investor can put a $1 million retirement account into dividend stocks averaging 4%, they will walk away with $40,000 in annual pre-tax income without touching their savings. (Remember that capital gains are taxed at a lower rate than regular income)
If you are trying to grow your assets, reinvesting is always the best option. If you believe in a stock enough to put your money there, you should believe in it enough to increase your position organically through a dividend reinvestment.
How to Start a Dividend Reinvestment
You can reinvest your dividends through one of two methods, from your broker or a DRIP.
First, you can simply select the option to “reinvest” when you buy a stock through your stock broker. In my account, it is just a simple check box on the buy screen.
Second, you can buy into a DRIP (dividend reinvestment plan) directly from the company, though the fees may be higher than from a discount broker.
What is Your Best Option?
Each investor must decide what their goals are and how to build a portfolio to reach those goals. If you are in retirement, or near to it, the best option is to take the cash. Otherwise, most investors should opt to reinvest their dividends.
What do you chose to do with your dividends? Please share your thoughts in the comments.
Originally written December 16, 2008. Updated March 25, 2013. Image by jmoneyyyyyy / flickr.