If you've ever had a savings account at your local bank you've experienced the power of compound interest. The bank paid interest on the money you had in savings and credited that amount to your account. Then you started earning interest on the interest, which made your savings grow even faster. You can get a similar type of growth in your stock investments by participating in a dividend reinvestment plan.
A company that earns profits can either retain those profits and use them to fuel additional growth or pay them out to the company's stockholders in the form of a dividend. Some companies might choose to do a combination of retaining some earnings toward future growth and paying a portion of the earnings as dividends. Companies that use their profits to expand their markets, increase research and development or build new stores are commonly referred to as growth stock companies. The stocks of mature companies that have a long history of paying out dividends in both good and bad economic times are often call blue chip stocks.
Dividend Reinvestment Plans
When a company pays a dividend it typically sends the dividend to you or your broker if your stock is held in street name. Some companies offer their shareholders the option of having their dividends reinvested back into additional shares of company stock. While features of dividend reinvestment plans vary from company to company, one major advantage is their automated nature. Once you are enrolled, you don't have to do anything. Additional shares of company stock, which might include partial shares, are purchased automatically on your behalf. Some plans even pay the brokerage fees for such purchases. The new shares are eligible for the same growth and dividend payouts as the original shares.
Growth vs. Dividend Reinvestment
Growth, when it comes to your stocks, usually means the increase in the stock's market price over what you paid for it, but growth can also refer to the number of shares you own. For example, if you bought 100 shares of XYZ growth stock for $40 per share and three months later the market price increased to $44 per share, your stock has growth of $4 per share and your portfolio is now worth $4,400. Now assume you bought 100 shares of blue chip ABC stock for $40 per share and signed up for the company's dividend reinvestment plan. Three months later the board of directors declared a dividend of $4 per share. The plan would automatically reinvest the $400 dividend into additional company stock. Assuming the price per share of the stock has remained unchanged, you now have 110 shares of ABC stock worth $4,400.
In the previous examples, both investments resulted in a portfolio worth $4,400, but there are some significant differences. The IRS considers the dividends paid on the ABC stock to be taxable income, while the growth in market price of the XYZ stock is not subject to current income taxes because you haven't sold it. The growth on the stock is only taxed once you dispose of it, at which time it will be taxed as either a short-term or long-term capital gain, depending on how long you have held it. While dividend reinvestment plans may be compared to compound interest on your bank account, stock investments are not insured by the Federal Deposit Insurance Corporation or any other federal agency. Even blue chip companies can fall on hard times and reduce or suspend dividend payments.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.