What is a Dividend Reinvestment Plan (DRIP)?
A dividend reinvestment plan (DRIP or DRP) is a plan offered by a company to shareholders that it allows them to automatically reinvest their cash dividends in additional shares of the company on the dividend payment date. Dividend reinvestment plans are typically commission-free and offer a discount to the current share price.
Types of Dividend Reinvestment Plans
The three common types of dividend reinvestment plans are:
1. Company-operated DRIP
The company operates its own DRIP and a specific department handles the entirety of the plan.
2. Third party-operated DRIP
The company outsources the DRIP to a third-party that handles the entirety of the plan. This is usually done when it is too costly and time-consuming for the company to operate its own DRIP.
3. Broker-operated DRIP
Some companies may not offer a DRIP, but brokers may provide a DRIP on some investments to investors. With a broker-operated DRIP, brokers purchase shares on the open market. Typically, depending on its relationship with clients, brokers will charge little to no commission for DRIP stock purchases.
Example of a DRIP
Mary owns 1,000 shares in a real estate investment trust (REIT) and participates fully (100%) in the company’s dividend reinvestment plan. The REIT declares a dividend of $10/share payable on December 1. On said date, the market price of the share is $100, and the dividend reinvestment plan offers a 15% discount. With full participation in the company’s DRIP, how many additional shares will Mary be able to purchase in the DRIP?
On December 1, Mary receives a cash dividend of $10,000 (1,000 shares x $10). Mary fully participates in the DRIP, thereby reinvesting 100% of her cash dividends into additional shares of the company. On the payment date, the market share price is $100. With a 15% discount from the DRIP, Mary is able to purchase additional shares at a price of $85 ($100 x 0.85).
With a purchase price of $85 and $10,000 in cash dividends, Mary will now own an additional 117.6471 shares ($10,000 / $85) in the real estate investment trust. Typically, the fractional amount (0.6471) is carried toward the next dividend payment. Therefore, with the DRIP, Mary will own an additional 117 shares.
Advantages of a Dividend Reinvestment Plan
A dividend reinvestment plan offers the following advantages:
1. Accumulate shares without paying commission
Shareholders are usually not charged a commission or additional brokerage costs when purchasing shares through DRIPs. Therefore, they save on transaction costs when participating in a DRIP.
2. Accumulate shares at a discount
Most companies offer a discount to the current market price of their shares. Shareholders are able to purchase shares at a lower cost basis when participating in a DRIP.
3. Compounding effect in action
Due to the automatic reinvestment of cash dividends, DRIPs help investors achieve compounding returns. Reinvestment leads to compounding, which grows the investment faster.
For example, consider an investor that receives a cash dividend on his shares. The investor fully participates in a DRIP and reinvests the cash dividends for additional shares. During the next dividend payout, the investor will receive more cash dividends due to the additional shares purchased through the DRIP. The cycle of reinvestment compounds the investor’s returns and increases the return potential.
4. Acquisition of long-term shareholders
Shareholders that participate in a DRIP typically adopt a long investment horizon. Therefore, a DRIP is advantageous for companies looking to create a base of loyal, long-term shareholders.
5. Creation of capital for the company
DRIPs allow a company to generate more capital. The company is able to raise additional capital by directly giving shares to shareholders in return for cash dividends.
Disadvantages of a Dividend Reinvestment Plan
Along with its advantages, a dividend reinvestment plan comes with some disadvantages, too, including the following:
1. Dilution of shares
As the company issues more shares to shareholders, more shares will become outstanding in the market. Therefore, shareholders that do not participate in the company’s DRIP will see their ownership base diluted.
2. Lack of control over the share price
Since the shares are automatically purchased, the investor exerts no control over the price of the stock. They could end up investing in the stock when the share price is very high.
3. Longer investment horizon
A DRIP is not suitable for short-term investors, especially if the company is paying its dividends semi-annually or annually. Instead of waiting to receive the additional shares by the end of six months or a year, the investor can decide to buy the shares from the market at once.
4. Bookkeeping purposes
Shares that are acquired through DRIPs are taxable – they are considered to be income even though the actual cash dividend was reinvested. Therefore, shareholders are required to maintain records (i.e., a record of a transaction, cost base, capital gains/losses) for the purpose of tax reporting. It can be troublesome and time-consuming for investors.
5. Lack of diversification
A DRIP increases an investor’s exposure to the company. As the investor acquires more shares through the DRIP, their portfolio will be more heavily exposed to the company. DRIPs may prompt the need for an investor to rebalance his or her portfolio periodically.
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