Recently I have been struggling with how to adjust my portfolio metrics when I reinvest the dividends I receive. What effect, if any, does the dividend reinvestment have on my cost basis and average cost per share? What about my yield on cost (YoC)? I have posed these questions to some of my fellow dividend growth investors and I have received mixed responses.
Most people fall into two categories. One category I will call the “free shares” group. They believe that reinvested dividends have no affect on cost basis and therefore receive shares for “free.” This decreases the cost per share every time a dividend is reinvested and dramatically increases YoC over time. The other category I will call the “purchased shares” group. This group treats reinvested dividends as a new purchase, thus increasing the cost basis and changing the cost per share and YoC (these could be higher or lower depending on the purchase price).
So which group is right?
I have done some research and I have reached a conclusion. From a technical standpoint, the “purchased shares” group is correct in terms of tax preparation – your gains or losses will be based on your average cost per share, which includes reinvested dividends. Logically, I also believe the “purchased shares” group is correct. The dividends that investors receive are income – cash deposited into an account that the investor can use for anything. Automatic or not, the investor is making a choice to purchase shares of a stock at the current price, yield, etc, and therefore it should be treated as a purchase.
That said, for long-term dividend growth investors it doesn’t matter which group you belong to because two of the most important metrics, position value and dividend income, remain the same regardless of your dividend reinvestment accounting method (see below). People using the “free shares” method just need to make sure they report the appropriate cost basis if the shares are sold in order to avoid massively overpaying capital gains tax (again, see below).
How do these dividend reinvestment accounting methods affect portfolio metrics?
Here is a scenario to compare the two different methods using the following assumptions for the fake stock XYZ:
Initial Investment: $50,000.00
Starting Share Price: $100
Starting Quarterly Dividend: $0.75
Annual Share Price Growth Rate: 5% (compounded quarterly)
Annual dividend Growth Rate: 5% (compounded annually)
This initial purchase gives us 500 shares of XYZ with a dividend yield of 3% and a forward annual income of $1500. Now lets see what our various portfolio metrics look like comparing the “free shares” and “purchased shares” dividend reinvestment accounting methods over a 20 year time period, starting with the metrics that differ dramatically.
For the “free shares” method, shares are being accumulated while the cost basis of the position remains the same. This results in a huge discrepancy in the average cost per share. Going back to tax reporting, if an investor from the “free shares” category decided to sell their shares after 20 years, they might make the mistake of using an average cost per share value of $56.28 (or a cost basis of $50,000) to calculate their gains. This would result in a reported gain of $187,027.60 compared to a reported gain of $118,475.62 for the “purchased shares” investor. If not careful, the “free shares” investor could wrongfully pay taxes on an additional $68,551.98. Luckily, most brokerages (including Tradeking) track this automatically so there is no need to worry. I am simply using this as an example of why the “purchased shares” method is technically correct.
The annual dividend rate of a security divided by the average cost basis of the investments.
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The key phrase here is “average cost basis.” I think I’ve made my point above that the average cost basis must include reinvested dividends, so by definition the “purchased shares” method more accurately measures yield on cost.
Does any of this really matter? Assuming you report the correct numbers during tax time, the answer is no – and here is why:
At the end of the day we all have the same position value and receive the same dividend income no matter what method we use. So to each his/her own. Personally, I will be adding the dividend reinvestment to my cost basis for all of my positions moving forward.
The complete data table used to generate these graphs can be viewed in Google Docs HERE.
What are your thoughts on these methods?