I have had a few readers ask about the difference between two key strategies inside of an ESPP – Selling Covered Calls and Dividend Reinvestment. I haven’t really covered Dividend Reinvestment yet so can’t do justice with a comparison of the two here on the blog. I’ll put this post together and later do some comparison of the two ESPP strategies.
Both of these strategies are ideal for ESPP where the stock has a dividend, mostly due to the compounding relationship (as any dividend paying investment provides). The idea of Dividend Reinvestment is centered on holding a stock and growing a position in the stock over a long period of time. To support this goal, all dividends (distributions of corporate earnings) are used to purchase more shares of the company. This means that as the dividends are paid out they are reinvested in the stock. This reinvestment naturally increases the number of shares and thus the total dollar amount during payout time. Yes, that means more money.
As with the covered call strategy, dividend reinvestment can be used on accounts outside of an ESPP and does very well there. Inside of an ESPP dividend reinvestment has the advantage of starting from a lower basis than if you were to purchase the shares on the open market. This means that if you are receiving a 10% discount on a $50 stock, you will start with buying the stock for $45 vs. $50 – assuming a $900 investment that means you will own 20 shares vs. 18 shares. To start this sounds simple; however, those two extra shares or 20 or 200 extra shares (depending on the scale of your account) will garner more dividends during the dividend payouts.
If your stock is paying 5% in dividends that is $2.50 per share (times two) or $5 extra cash in your hand as a result of the ESPP discount (or $50 or $500 depending on the scale of your account). Assuming the scale of your account is closer to $9,000 than $900 you would be able to purchase one extra share every time there was a dividend payout above what you would normally be able to purchase, in other words the compounding affect would be greater and you would get richer.
In fact, this example is incredibly interesting when we compare something like a 30 year timeframe (which after all should be the timeframe you are looking at for quality value investments). A recent article on Seeking Alpha discusses this concept in regular accounts and presents an analysis of a dividend reinvestment strategy for Proctor and Gamble $PG. The article assumes using $10,000 to purchase stock in 1982 (to give us 30 years of growth). At the end of the thirty year timeframe this gives you 8,964 shares (each paying $2.25 per year) which gives you an income of $20,000 per year (that is twice what you paid to start with)… Just think if you would have invested 10,000 per year each year over the same 30 year timeframe (you would be earning $500,000 per year by now).