A dividend Reinvestment plan is the option opted by the investor to reinvest the amount of cash dividend payable by the company to that investor into the new shares of the underlying securities on the date of the payment of dividend thereby saving the brokerage and other fees that is incurred if the same cash is used to purchase the shares from the market.
What is a Dividend Reinvestment Plan?
Dividend Reinvestment Plan, also known as DRIP, is a plan wherein investors have an option to reinvest their dividends to purchase additional shares of the underlying stock on dividend payment date rather than taking the dividend out. Most DRIPs allow the shareholders to purchase shares at nil commission and at a discounted price. In general, price discount varies from 1% to 10%.
In a normal scenario, a person receives dividends from a share through checks or bank transfers, however, in the case of DRIP, dividends are not received by the investor, they are automatically used to purchase more shares of issuing company. Further, the DRIP is not traded on exchanges and hence are not marketable directly. Dividend Reinvestment Plans are typically issued from the company’s own reserves and hence are redeemable through the company itself.
Example of a Dividend Reinvestment Plan
Investing in DRIP vs. buying shares directly through cash dividend received:
Say One has stocks of ITC limited at INR 300 each and suppose it pays a half-yearly dividend of approximately INR 6.0 per share. So one holds 1000 shares, the half-year dividend would be INR 6000.0. For understanding purpose, let’s assume the half-yearly dividend and the share price remains constant for the next 6 years. So, if one enrolls the ITC limited shares for Dividend Reinvestment Plan with the above condition, the first half-year dividend will let one buy 20 additional shares:
However, consider if one doesn’t go for Dividend Reinvestment Plan and goes about reinvesting the dividends on their own through brokerages:
So if in the same scenario as mentioned above, say the brokerage per share is INR 10.0 and commission and taxes include INR 5 per share. So the first dividend of INR 6000 will provide 19 shares and a cash balance of INR 15 (1200 – a cost of 19 shares – brokerage for 19 shares – commission + taxes for 19 shares). So:
So, it can be seen that there is a difference of 12 shares in both cases. It may not seem like a huge difference at first, but for a long term purpose, it makes a huge difference. Further, if we consider the fact that Dividend Reinvestment Plan shares are available at a discount of 1% to 10% from market price, it will further add up to the value creation.
Advantages of Dividend Reinvestment Plan
- Dividend Reinvestment Plans allow the shareholders to reinvests their dividends without any additional commission or brokerage being charged. If a person goes directly to reinvest their dividend received from the company through brokerages they will have to pay brokerage/commission which makes it a costly way of investment. Hence DRIPs area cheaper way of dividend reinvestment.
- DRIPs provide an option to purchase fractional shares. For Example: If a person is holding 105 stocks of a company that is trading currently INR 100 each and receives a dividend of INR 5 per share, so the person will receive a dividend of INR 525. Now in case of the Dividend Reinvestment Plan, considering the stock price of INR 100 per share, a person will receive additional 5.25 shares in his account.
- In the case of the Dividend Reinvestment Plan, a dividend is reinvested in shares at a price lower than the current market price which is not the case with manual reinvestment.
- Dividend Reinvestment Plan is particularly good for long term investments. They allow the shareholder to accumulate more shares without investing further money from their regular income.
Disadvantages of Dividend Reinvestment Plan
- Shares are not as liquid as one purchased in the open market. One needs to approach the company to sell shares and hence cannot readily sell shares considering sudden market condition changes.
- Not suitable for short term investors as it does not provide significant returns
- The purchase price of stocks is decided by the company, hence investors have no control over the purchase price. Further, if a person wants to average out its cost price in case of a sudden downturn in stock price, it is not possible since there is a timeframe for optional additional cash investment for DRIP.
Points to Remember while Investing in DRIPs
- Most DRIPs don’t charge fees or commission/brokerage, but nowadays, it is becoming a trend to charge a nominal fee to invest in DRIP shares. The fee may range from a few INR to tens or hundreds of INR depending on the current prevailing price of stock in the market. It is important to check if there are any initial fees or commission charges for the plan and if any same should be considered while assessing the profitability of the plan.
- Some Dividend Reinvestment Plans require investors to become shareholders of record. Shares must be registered in the individuals’ names and not any brokerage’s name. Post becoming a shareholder of record, application for DRIP purchase needs to be submitted to the company
- DRIPS also offers optional cash payments wherein one can further invest cash directly into DRIPS. However, the timeline for optional cash payment varies from company to company. Further, there is a maximum and minimum optional cash investment which is defined. Thus, same should be taken into consideration prior to investment in Dividend Reinvestment Plans
- Though one does not receive the dividends in their account, one has to pay dividend payout tax in the case of DRIPs as well. It is a normal notion that people have that if they have not received the cash dividends in their account, why do they have to pay taxes on it. Thus one needs to consider the tax implications as well while calculating the returns of the Dividend Reinvestment Plan.
Dividend Reinvestment Plan (DRIP) is a good investment strategy especially for the long term, but like any other investment instrument, one needs to put in proper research work and due diligence before investing in DRIPs. One must take into consideration the background of the company, the industry in which it operates, its financial strengths, future growth prospects, etc. If Dividend Reinvestment Plans are taken without proper considerations, it may become a huge cost for the investor.
This has been a guide to the Dividend Reinvestment Plan (DRIP). Here we discuss its definition along with an example. Here we also discuss its advantages and disadvantages. You may learn more about financing from the following articles –