What is a Dividend Reinvestment Plan?

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.

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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:

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 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.

Advantages

  • Dividend Reinvestment Plans allow the shareholders to reinvest their dividends without charging additional commissions or brokerage. If a person goes directly to reinvest their dividend from the company through brokerages, they will have to pay brokerage/commission. It will make it a costly way of investment. Hence DRIPs are a 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.read more. For Example, A person is holding 105 stocks of a company. It currently trades at INR 100 each and receives a dividend of INR 5 per share. So the person will receive a dividend of INR 525. In the case of the DRIP, considering the stock price of INR 100 per share, a person will receive an additional 5.25 shares in his account.In the case of the Dividend Reinvestment Plan, the reinvestment of dividends 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.read more.This plan is particularly suitable for long-term investmentsLong Term InvestmentsLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets.read more. They allow the shareholder to accumulate more shares without investing additional money from their regular income.

Disadvantages

  • 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 returnsThe 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 stock price downturn, it is impossible 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.read more 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 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.

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 –

  • Dividend Examples ListDividends TypesDividend Policy DefinitionQualified Dividends