What is a DRIP (Dividend Reinvestment Plan)?
A DRIP (Dividend Reinvestment Plan) allows investors to reinvest any dividend earnings they receive back into the stock of the company paying out the dividend. DRIPs give stock market investors who own shares in a particular company the opportunity to receive dividend payments either in the form of additional shares of that company or as a discount towards future purchases of that company’s shares.
Dividend Reinvestment Plans are particularly popular among passive investors who don’t want to spend a lot of time studying the stock market and picking specific companies to buy or sell. They can allow such investors to grow their portfolio without necessarily exerting too much effort. However, DRIPs are very illiquid investments as they tie up capital for a longer duration than a normal equity investment. In addition, most plans don’t provide any tax advantage as the extra company stocks are treated as capital gains and taxed accordingly.
Companies that are listed on stock exchanges are publicly held companies and as such, list millions of shareholders. Every shareholder is entitled to receive a share of the company’s profits that the company has not invested back into the business. Publicly listed companies distribute their excess profits back to shareholders using dividend payments.
A company that is paying out a high dividend could be doing so either because it is making large profits or because it is winding down its operations and preparing to shut down. In the latter case, the dividend payments are made using proceeds from asset sales. Therefore, a high dividend can’t be seen as a sure sign of a good stock investment.
Similarly, a company that is paying out a low dividend could be doing so either because it is making small profits (or losses) or because it is expanding operations. Therefore, a low dividend can’t be seen as a sure sign of a bad stock investment.
DRIP – Illustrative Example
An investor owns 1,000 shares of Apple Inc (NASDAQ:AAPL) priced at $200 per share. The investor is confident that Apple’s stock price will rise in the future and enters into a dividend reinvestment plan with the company. Apple declares a dividend of $8 per share or 4%. Since the investor owns 1,000 shares of Apple, he would’ve received $8,000 in cash if he was not enrolled in the dividend reinvestment plan. Since he is enrolled in the DRP, he receives an additional 40 (Cash Dividend Amount / Share Price = 8,000 / 200) shares of Apple.
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