Should you reinvest your dividends?

Everybody loves dividends. John D Rockefeller, often regarded as the richest person in modern history, once said, "do you know the only thing that gives me pleasure? It's to see my dividends coming in."

However, investors are often indecisive on how to spend their dividends. Should you use it as a source of income, as many income investors do, or should you reinvest them in the same business to further fuel your capital appreciation?

When to reinvest
Many investors favour the dividend reinvestment strategy because of the potential snowball effect it can generate. If a company keeps paying high enough dividends without sacrificing its growth prospects, reinvesting your dividends to purchase more stocks of the company seems like a no-brainer. However, this strategy is only possible if the dividend received is large enough to purchase additional shares of the company.

To show how reinvesting dividends can boost your returns, we looked at the following two metrics of BSE companies.

Price return including dividends: This metric represents capital gains along with the dividends that were paid during a given period. However, it assumes that the dividends were not reinvested in the company.

Total return: This metric represents the total return an investor would get if the dividends were reinvested in the company.

The table below lists the top 10 companies (market cap > Rs 500 crore) in the BSE that delivered far greater total returns as compared to price returns (incl. dividends) over the last 10 years.

As you can see, the top eight companies in this list gave an additional return of at least Rs one lakh to those who reinvested the dividends.

When not to reinvest
Does this mean you should always reinvest your dividends?

No, not if the company has poor growth prospects.

For example, these are the BSE companies whose price returns (incl. dividends) exceeded the total returns over the last 10 years. In other words, investors who chose not to reinvest their dividends in these companies got better returns.

However, it is important to mention that poor growth is not always a symptom of a fundamentally weak company. Poor capital appreciation can stem from many factors, such as high competitive intensity, sectoral headwinds, etc.

Moreover, mature companies that have lived past their growth phase often don't have much legroom for growth. You might have bought them at very attractive prices and perhaps are right in holding on to them for their lucrative large dividends.

However, you would be far better off investing these dividends in companies with a larger runway for growth.

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