When a company makes profits, it has three options:
1. Reinvest the cash in its operations. This is the option privileged when a company is growing fast and sees plenty of investment opportunities.
2. Pay down its debt obligations. This is an option that is unfortunately sometimes not optional but necessary.
3. Pay a dividend to reward shareholders for their investments and continued support.
Let’s start by the beginning and let’s review together what is a dividend. There are different ways to describe a dividend but a short and simple definition can be that a dividend is a reward that a company gives to its shareholders on a per-share basis. This reward can come into two forms: cash most of the time but it can also take the form of giving the shareholder additional shares of the company.
Once you have received the cash as a shareholder, you have three options:
1. You can withdraw the cash from your account and spend it as you wish. This is fun but this is of course not optimal for the future.
2. You can leave the cash on your account and just wait for an opportunity or better market conditions to reinvest it. This can be a risky move since it is almost impossible to time the markets.
3. Or finally, you can use the cash to re-invest it in additional shares.
The third and last option described above is a strategy that can pay off big time in the long-run.
Reinvesting dividends is one of the best way to build wealth over time. However and as always, things are never that easy and there are additional things to consider. First, it may not be the right choice for every investor and second the success of this strategy will be dependent of timing and current stock valuation!