DRIPs are "dividend reinvestment programs" (or sometimes "dividend reinvestment plans"). What are they and why should you be considering them for your investment portfolio?
We have talked about compound interest and how you can harness its amazing power over a long period of time. Compound interest is earning interest on interest. When it comes to stocks, though, you may want to substitute the word interest with dividend. One of the best ways to earn dividends on your dividends is by signing up to a DRIP.
Dividends are usually made as cash payments to you that are either paid into your brokerage account, or paid directly into your checking account. You can also receive dividend checks. As mentioned in our article "what are dividends", dividends are a reward to you as an owner of the company and form an important part of your returns.
You have several options with those dividends. Perhaps you are retired or need the income and decide to spend it. You may need it for every day necessities like groceries or the electricity bill or you may wish to splash out on a nice vacation or a new car. Another option maybe to gift the cash to relatives or charities.
The final option, though, is the one we'll focus on which is to re-invest this cash. This is the way to turbo charge your way to wealth and take advantage of compound interest. This option is most likely to be available to you if you don't need the cash right now as perhaps you are working or you have other savings/income.
A dividend reinvestment program is where a company allows you, the investor, to reinvest your cash dividends by purchasing additional shares in that company. DRIPs are sponsored by the company and you purchase the stock directly from the company through their transfer agent. A transfer agent is the company that administers the share registry and investor record keeping of a company. Examples of transfer agents include Computershare and American Stock Transfer and Trust (AST).
1) Many dividend reinvestment plans (although not all) will allow you to purchase the additional stock at a discount to the current market price. The discount can vary and every program is different but is usually in the 2-5% range.
2) Cost! Most dividend reinvestment plans will allow you to purchase the extra shares with no commission or at least at a very low cost.
3) Dividend reinvestment plans will often allow you to purchase fractional shares. For example, if you are paid a $90 dividend and the DRIP is allowing you to purchase additional shares at $60 then you will be receive 1.5 shares. This will entitle you to further fractional dividend payments.
4) Most dividend reinvestment plans will allow you to add further voluntary cash contributions to the program allowing you to purchase more shares.
5) Dividend reinvestment plans mean you automatically purchase shares without really thinking about it. This could be particularly advantageous when the market has crashed and you don't feel like buying stock. As we have mentioned elsewhere on the site, purchasing stock when the market is very weak is often a very shrewd move and a DRIP means this is done automatically, It also saves you from making constant decisions about how to allocate capital meaning you can get on with your life while dividend reinvestment programs gradually go about increasing your wealth.
DRIPs are not a giveaway from the company. They actually raise cash for the company. This is because they receive the cash from your dividend in exchange for increased equity capital. This does mean that if you don't subscribe to a DRIP from a company that offers them, then all other things being equal, you will be gradually diluted.
There are other advantages to the company. This may include better goodwill and general engagement from shareholders as the company offering a DRIPis more likely to have a stable and loyal shareholder base. DRIPs are also more likely to attract retail or individual investors who are more likely to be loyal shareholders and longer term shareholders.
Most brokers do offer a dividend reinvestment program but you need to be careful over their fees. Check what they charge you to sign up to the broker DRIP. You will also need to check whether the broker allows you to buy fractional shares as, if they don't, they will effectively be holding your cash until you have enough to buy a full share.
Although a dividend reinvestment program can be offered by brokers, you can only enrol in the official plan if you are a registered shareholder. If you buy through a broker, then you are normally excluded from directly participating in the DRIP. This means you are less likely to be able to purchase the shares at a discount to the market price.
That said, an advantage to buying stocks through a broker is that if you have a portfolio of many different stocks then you can choose to let the cash pile up from various dividends and then decide yourself which shares to buy. You then have more control, so you don't end up buying more shares in a company that you think is overvalued. It also gives you the opportunity to purchase stock in a new company that you may have your eye on.
Tax - our favorite subject! As always, it depends on your personal situation and how you hold the stock.
Unfortunately, though, there is no favorable treatment to DRIPs from a tax perspective. This is because cash was effectively paid to you and forms part of your income. When the cash is reinvested into new shares, the amount is averaged into your purchase price and will be liable for capital gains tax as well. We add the usual disclaimer when it comes to tax... please speak to your financial advisor.
For a typical example of a dividend reinvestment program, take a look at the Johnson and Johnson DRIP here: www.investor.jnj.com/drip.cfm