Contributor Eric Tippelt shows us the dividend investing magic of compounding through DRIPs

Eric Tippelt | February 7, 2017 | SmallCapPower: There are really only two ways to make money on a stock. The first one is the most common, you buy the stock at $1.00 and it goes up to $2.00. This is called Capital Appreciation, or Fantastic! This is what every investor hopes happens with every stock.  And it does, more often than you think. Enerdynamic Hybrid Technologies Corp. (TSXV: EHT) is an example that comes to mind. I bought it in November for $0.10 a share, I sold it in December for $0.21 a share.

There is another way of making money off a stock that isn’t as exciting or dramatic. This is with DIVIDENDS. “Dividends are a portion of a company’s earnings paid to shareholders that is proportional to the number of shares owned.” (Source: TSX website) Not every stock will pay dividends.

Dividends normally come from well established, profitable companies. It is a way of rewarding shareholders with cash while, at the same time, often benefiting the price of the company’s shares. There are lots of reasons why companies pay dividends, but most investors look for dividends as a stable, predictable way to generate income.

Let’s look at how this works. We will use Royal Bank of Canada (TSX: RY) as an example. RY pays a quarterly dividend of $0.83 per share. That does not seem like a lot considering that Royal Bank’s stock price is currently $94.90. If, for example, you buy 10 shares of RY it would cost you $949 (plus commission). Thus, every three months Royal Bank will pay you $0.83 x 10 shares, or $8.30.

So not only do you have a chance of having the stock go up but you also have the advantage of getting $8.30 in dividends every three months. Nice. The advantage of dividends is that say next quarter the stock has gone down to $90.45. You are down on the share value of RY, but you will still get the $8.30 dividend.

Yes. Dividends go up, and they go down. This makes sense, because dividends are paid out of profits. Normally if a dividend goes down, so does the price of the stock. If the dividend goes up, so normally will the price of the stock.

Many stocks have another big advantage of dividends. It is called a DRIP: Dividend ReInvestment Plan. I call it compound interest on stocks. If you are buying and holding, this can be huge over the course of a few years. Let’s use RY as an example again. RY does have a DRIP program. Here is how it works.

Instead of giving you the $8.30 dividend as cash, they sell you more shares. Seeing that RY is trading at $94.90, the Company will hold onto your dividends until enough money has accumulated to purchase one share. The big advantage, however, is you also get these shares with no commission or trade fee when you sign up with a DRIP program.

Once you receive those DRIP shares the real magic begins. Instead of getting dividends on 10 shares you get dividends on 11 shares, or $9.13. That is why I call DRIPs compound interest on stocks. If you decide to sell the shares, you get the sell price on all of the shares you own either bought or DRIPed.

When looking at dividend stocks, it is important to look at the relation of Stock price to Dividend.  This is usually displayed as “Yield” and expressed as a percentage.  The higher the Yield the better.

If you have several thousand dollars to invest, the price of the shares might not mean as much, you can judge by yield %. If you are a smaller investor, it might be wiser to buy a lower priced and possibly lower yield share and get more of them. If you want the advantages of a DRIP make sure you have enough shares so that the dividend is higher than the price of one share.

Eric Tippelt is a full time professor of electrical automation at Loyalist College in Belleville.  He has been studying money and finance since 2004 when he began his online trading activities. Eric writes about Micro Investing ($500.00 to $1,000), because there is very little information out there on how to invest at that level.