What is a Dividend Reinvestment Plan?
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. The reinvestment is 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.
Another term for it is DRIP. The 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 buy shares at nil commission and a discounted price. In general, price discount varies from 1% to 10%.
In a typical scenario, a person receives dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company. from a share through checks or bank transfers. However, in the case of DRIP, dividends are not received by the investor. Instead, they automatically purchase more shares of the 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 reserves and thus are redeemable through the company itself.
Example of a Dividend Reinvestment Plan
Investing in DRIP vs. buying shares directly through cash dividendCash DividendCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer. 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 DRIP and goes about reinvesting the dividends on their own through brokerages:
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. 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). Thus:
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 add up to the value creation.
- Dividend Reinvestment Plans allow the shareholders to reinvest their dividends without charging any additional commission or brokerage. If a person goes directly to reinvest their dividend received from the company through brokerages, they will have to pay brokerage/commission. It will make it a costly way of investment. Hence DRIPs area cheaper way of dividend reinvestment.
- DRIPs provide an option to purchase fractional sharesFractional SharesFractional share refers to just a part of equity stock which doesn't amount to a single stock unit. Such shares are acquired after stock splits, merger or acquisition, dividend reinvestments, capital gains and dollar-cost averaging. The shareholders cannot sell these stocks in the open market.. For Example, A person is holding 105 stocks of a company. It is currently trading at INR 100 each and receives a dividend of INR 5 per share. So the person will receive a dividend of INR 525. Now in the case of the DRIP, 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, the reinvestment of dividend happens in shares at a price lower than the current market price. It is not the case with manual reinvestmentReinvestmentReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio..
- This plan is particularly suitable for long term investments. They allow the shareholder to accumulate more shares without investing further money from their regular income.
- 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 company decides the purchase price of stocks. 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 investmentCash InvestmentCash investment is the investment in short-term instruments or saving account generally for 90 days or less that usually carries a low rate of interest or the return with a comparatively low rate of risk compared to other forms of 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 a stock in the market. It is essential to check if there are any initial fees or commission for the plan. If so, one needs to consider that while assessing the profitability of the plan.
- Some DRIPs require investors to become shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. of record—registration of shares in the name of individuals and not any brokerage. Post becoming a shareholder of record, one needs to submit, application for DRIP purchase 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, one needs to consider that before investing 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 common 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. Still, 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 taken without proper considerations, these plans may become a massive cost for the investor.
This article 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 –