Last Updated on 21 November, 2023 by Samuelsson
Compounding dividends and DRIP investing are popular. That is understandable because dividends have significantly contributed to long-term gains in the stock market. It’s essential that you reinvest dividends to get the returns of the market, but many investors mistakenly focus solely on dividend stocks because of this. But a company has many opportunities to allocate capital:
A company that can reinvest/redeploy retained earnings at acceptable returns, is usually far more preferable than reinvesting a dividend into the same company (or using the same dividend to compound in other stocks).
In this article, we explain why DRIP/dividend investing is inferior to internal compounding, ie. reinvesting the retained earnings back into the business is better than paying a dividend.
Instead of compounding the dividends, it’s much more efficient to compound internally into the business. Here’s why:
Compounding dividends and the dividend bias
Many investors have a strong focus on dividends, so much that I would like to call it an irrational dividend bias. These investors like to get a dividend for “income” or reinvest and compound the dividends.
Dividend investors focus only on dividend stocks, and for the most part ignore stocks that don’t pay dividends. Thus, they leave out a huge segment of the market that has the potential of compounding faster than dividend stocks (as this article will show you).
DRIP/dividend is simply an extremely inefficient way to compound (in most cases), but this article is not a case against dividends. Some companies simply generate so much cash that they have to distribute it. As an investor, you are well-advised to make sure you have an agnostic view on how to compound the most efficiently.
I quote Warren Buffett from Berkshire’s shareholder letter of 2012:
Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)
Over the long-term, the earnings, either reinvested or distributed, are the main source of your compounding result. In other words, your initial capital is less important than how you reinvest the earnings!
This article explains why DRIP, compounding dividends, and reinvestment above book values are so detrimental to the future marginal rate of return and long-term compounding. Compounding dividends face a headwind in stocks trading at multiple to book.
You might want to read the other articles I have written on the subject of dividend investing before you read this one:
- Sell shares to create income
- The marginal rate of return/incremental return (strongly recommended to read this article before you read the one you are reading now)
- The foolishness of dividend investing
Let’s start by defining the two terms used in the headline:
DRIP and reinvestment above book value
DRIP is an abbreviation for dividend reinvestment plan. This is a program that allows investors to automatically reinvest the dividends into additional shares in the same company. DRIP is most common in the US and the UK. By dripping, you compound the dividends (let it grow).
Likewise, you can “DRIP” in other stocks: If you receive a dividend from for example Philip Morris and reinvest the dividend in Pepsi-Cola, the principles discussed in this article are just as relevant. The aim of the article is to show that companies that can redeploy earnings are usually a better investment than those which distribute it, given of course a reasonably high ROE.
DRIP works like this: If you receive 200 USD in dividends from Altria (MO), those 200 dollars are automatically converted to additional shares, about 5 shares at today’s prices. This is done without deducting for dividend taxes, which you have to pay out of your additional funds (if you are in a tax position).
Internal vs. external compounding
Internal compounding is when retained earnings are not distributed to shareholders but reinvested into the existing business (or, for example, used to pay back debt, etc.).
External compounding means that retained earnings are returned to shareholders, mostly via dividends, and the compounding burden is handed over to you.
Managements often mouth that paying a dividend is doing something for the shareholder, but it’s precisely the opposite: management simply sees no opportunities for reinvestment, and you, as an investor, have to get off your ass and spend time reinvesting those same funds.
Dividends have three caveats
The first is taxes. Research shows dividend-paying stocks have outperformed non-payers, but this is before considering taxes on the dividends. Most investors are in a tax position, and this is of course a huge headwind in the real world.
The second is the opportunity costs. Could the dividend be better spent reinvested into the existing business?
The third is that it’s far easier to compound by retaining the earnings than distributing via DRIP and compounding.
The example below illustrates the growth of two investments::
An example of a dividend payer and one non-payer
This Google sheet provides a mathematical example of the performance of two identical companies:
Company A pays out 50% of the earnings as dividends which the investor subsequently DRIP at year’s end, and Company B which retains 100% of earnings. Both companies grow book value/shareholder’s equity at 10% and both trades at two times book value.
When Company A trades at two times book value, you reinvest the dividend at a 5% return on equity (ROE), not 10%, because you “exchange” your equity for 0.5 equity.
This means that the CAGR of the share price in Company A gradually gets closer to 5% as time pass. At two times the book value, the CAGR in Company A is only 7.5% over 20 years, much lower than 10% in company B. This means Company B is a better investment as long as it manages more than 7.5% ROE.
To keep up with Company B, which of course grows at 10% for all of the equity (because none is distributed to shareholders), Company A needs to have a 20% ROE to generate a 10% CAGR over 20 years (2x 10%).
If both companies trade at five times book value, the ROE in company B must be 50% (to keep up with the non-distributed 10% growth in Company B).
The table below summarizes the performance (CAGR) of these two companies with different premiums to book value:
No dividends (reinvestment)
|Company A||Company B|
|CAGR 20 years:||CAGR 20 years:|
If a stock trades at a discount to the book value, then it obviously makes sense to both pay and reinvest a dividend.
Gazprom (OGZPY) currently trades at about 0.5 times the equity which means that after reinvesting you own double the equity than before (you would be receiving a dollar in book value but reinvesting at just half the dollar, thus receiving 2x of the equity).
This additionally means that every dollar (or rouble) retained in Gazprom is only transformed to about 50 cents of market value.
In the letter of 1984, Buffett called the latter “gold-into-lead-process”, and meant that most earnings should be distributed back to shareholders in such a discount to book scenario.
The table above doesn’t include taxes on the dividend. If we include a 15% withholding tax we obviously see a further drop in the CAGR for the DRIP methodology:
No dividends (reinvestment)
|Company A||Company B|
|CAGR 20 years:||CAGR 20 years:|
Compounding dividends and DRIP – conclusion
Given two identical companies, you better choose the one which can reinvest earnings. It’s the most efficient way to compound! If a stock is trading at multiple to book, you face a headwind when compounding the dividend.
If a company doesn’t pay a dividend, you sell shares in the company to create “income” (if you somehow need cash), which is the same as receiving a dividend, actually better as long as the stock is trading at a premium to book value (sell shares to get income).
As I have often mentioned on this blog: why receive at par to equity when you can sell your equity at a premium (assuming the stock trades at a premium to equity, which most stocks do)?
– How does DRIP investing differ from internal compounding?
DRIP investing involves reinvesting dividends into the same or different stocks, while internal compounding is the reinvestment of retained earnings back into the existing business.
– Why is it suggested that internal compounding is more efficient than compounding dividends?
Internal compounding within the business is considered more efficient because it avoids taxes and offers better opportunities for reinvestment compared to DRIP investing.
– How does the tax impact of dividends affect the performance of dividend stocks?
The content mentions that taxes on dividends can significantly impact the performance of dividend stocks, especially when investors are in a tax position. This tax liability can be a headwind for investors.