Dividend Reinvestment Plan

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Dividend Reinvestment Plan?

A dividend Reinvestment plan is an 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 dividend payment. Thereby saving the brokerage and other fees 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 the 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, the price discount varies from 1% to 10%.

In a typical scenario, a person receives dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more 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 is not marketable directly. Dividend Reinvestment Plans are typically issued from the company’s reserves and thus are redeemable through the company itself.

Dividend Reinvestment Plan

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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.read more 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 if one holds 1000 shares, the half-year dividend would be INR 6000.0. For understanding, let’s assume the half-yearly dividend and the share price remains constant for the next six years. So, if one enrolls the ITC restricted shares for Dividend Reinvestment Plan with the above condition, the first half-year dividend will let one buy 20 additional shares:

DRIP example 1.1

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:

DRIP example 1.2

There is a difference of 12 shares in both cases. It may not seem like a huge difference at first, but it makes a huge difference for a long-term purpose. Further, if we consider that Dividend Reinvestment Plan shares are available at a discount of 1% to 10% from the market price, it will add to the value creation.

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Advantages

Disadvantages

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 for any initial fees or commissions for the plan. If so, one needs to consider that while assessing the plan’s profitability.
  • 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.read more of record—registering shares in the name of individuals and not any brokerage. After becoming a shareholder of record, one must apply for a 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 payments varies from company to company. Further, a maximum and minimum optional cash investment are 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 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 while calculating the returns of the Dividend Reinvestment Plan.

Conclusion

Dividend Reinvestment Plan (DRIP) is a good investment strategyInvestment StrategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more, especially for the long term. Still, like any other investment instrument, one needs to do proper research work and due diligence before investing in DRIPs. One must consider the company’s background, the industry in which it operates, its financial strengths, future growth prospects, etc. These plans may become a massive cost for the investor if taken without proper consideration.

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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 –

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