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How Reinvesting Dividends Can Generate More Dividends

Those who have been investing for a long time have probably enjoyed healthy inflows of dividends along the way. Dividends are considered a form of passive income enjoyed by investors as a result of their investments’ good business performance. However, an important question should crop up — what do investors do with the dividends which they receive?

Some investors may opt to spend their dividends, as they consider it as a form of “bonus” which they can use on entertainment or travel. While others may choose to save their dividends in their bank account, thereby bolstering their emergency funds.

What I would do though, is to park these dividends in a separate account known as an “opportunity fund”, which can be used for further purchases of even more dividend stocks. This is a concept known as “compounding“, and if you do it right then you could be on your way to retiring early.

Compounding through cash dividend reinvestment

Let’s look at a hypothetical scenario where a real estate investment trust (REIT) pays out a dividend of $0.05 per unit. An investor who owns 10,000 units of the REIT would receive a dividend of $500 a year. Assume too, for simplicity’s sake, that the share price of the REIT is at $1. If the investor used the full $500 dividend to purchase shares in the REIT, he would then end up with a total of 10,500 shares ($500 / $1 = 500 units + existing 10,000 units).

The following year, the investor would receive a dividend of $525 for his new unit-holding of 10,500 shares (assuming the same level of dividends per share). If he were to reinvest it by buying units in the REIT again, he would have added 525 additional units (assuming unit price at $1 unchanged). Through this simple example, the investor has managed to generate more dividends through the reinvestment of his yearly dividend.

Compounding through scrip dividends

Some companies have a scheme that pays out dividends in the form of shares, known as “scrip”, rather than in cash. Investors have the choice as to whether they would like to receive their dividends in cash or scrip, or a combination of both. The good thing about scrip is that it is usually issued at a discount of 5% to 10% off the volume weighted average price (VWAP) of the shares traded in the last few days. This means that existing shareholders would be able to “buy” these additional shares at a lower price than if they had taken the cash and used it to buy shares from the open market.

Scrip works the same way as the cash dividend reinvestment, as it slowly but steadily increases your shareholdings over time, and allows the investor to receive growing dividends

Get rich slowly

The above two methods are what I would call an effective and proven method to “get rich slowly”. By compounding our dividends over time, we let our dividends generate even more dividends for us, and it is a virtuous cycle that all investors should look to benefit from.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.