Dividend investors are a rare breed who are able to delay gratification and invest for the long-term. One of the ways many investors automate some of their dividend investing plans is to enroll in a dividend reinvestment plan, or DRIP, through their brokerage firm. In a DRIP, you're passively investing in high-quality companies who pay you, the shareholder, dividends for your trouble. It's a way to harness the power of compounding to build future wealth. Don't just reinvest your dividends in any stock though. Before you start a DRIP, you need a good understanding of how to evaluate a stock for dividend reinvestment.

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Dividend Aristocrats

The first necessary feature of a DRIP candidate is to hold status as a Dividend Aristocrat. Basically, this means that the company's stock is listed in the S&P 500 and has paid out, and increased, its base dividend for at least the past 25 years. It's no wonder there were only 57 companies that met those stringent criteria as of December 2019. 

If you want to simply Ron Popeil ("set it and forget it!") your dividend investing, picking a Dividend Aristocrat is a good bet. Most of the companies on the list take great pride in their unblemished record, and paying out dividends to shareholders is often one of the last cuts they'll make in tighter times. These stocks make excellent candidates for a DRIP because of their consistent payouts and low volatility.

Dividend Payout Ratio

So you've got your list of Dividend Aristocrats, but it's still a big list, and you probably can't buy 57 stocks right away. How do you narrow down your choices? The next factor you should look at is the payout ratio, which is simply the percentage of earnings the company is paying out in dividends. It's calculated by dividing earnings per share by dividends per share. 

How does this help you identify a good DRIP stock? Well, you want to pick a stock that pays a good chunk of its earnings to shareholders, but not so much that the company is over-extending itself. In general, a good DRIP stock will have a payout ratio between 35% and 55% (though certain stocks like real estate investment trusts are required by law to be at least 90%). This likely means it's a solid leader in its industry and is being careful to not take on too much debt by paying out to shareholders. ExxonMobil's (NYSE:XOM) current payout ratio of 154% may sound awesome at first (wow, that's so high, it must be great!), but that means they're paying out way more cash than they're bringing in and taking on debt to do it. 

Dividend Yield

Ok, hopefully there hasn't been too much math to scare you away. We're almost done picking a high-quality, low-risk stock where you can park your money for the long run. There's one more metric we need to evaluate to ensure a good DRIP candidate, and that's dividend yield.

Dividend yield is the percentage of share price that is paid out in annual dividends. Put another way, it's equal to a company's annual dividend divided by price per share, multiplied by 100 (to give you a percent). For example, a company that pays you a $2 dividend for every $50 share you own has a dividend yield of 4%. 

Why is yield important to a hands-off dividend investor? You want to make sure your money is actually going to work for you and that you're investing in healthy companies that return a good amount of wealth to the shareholder. Many dividend investors set a target dividend yield for their portfolios. While the yield will fluctuate based on the share price, your DRIP plan will help you dollar-cost average into shares so you're not trying to time the market. In general, a dividend yield of anywhere from 2.5% to 5% is where you're aiming. Compare it to other companies in the same industry to see whether it's abnormally high or low.

Automate Your Way to A Wealthier Future with DRIPs

If you're interested in reinvesting your dividends, you probably see the beauty and benefits of automation. It lets you live your life while reaping the rewards of compounding, and builds real wealth over the long-term. DRIPs are not a get-rich quick scheme by any stretch of the imagination, but they get you invested with some of the highest quality and lowest risk stocks on the market. Your future self will be grateful.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.