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What is a dividend reinvestment plan?

Posted on Thursday, September 12th, 2019 by MarketBeat Staff

Summary - A dividend reinvestment plan (DRIP) is an investment strategy that allows investors to receive growth in their portfolio by regularly reinvesting their cash dividends to buy more of the company’s stock. DRIP programs provide this capital appreciation regardless of the underlying company’s stock price. This makes DRIPs a solid option for both growth and income investors, but particularly those investors who have lower risk tolerance.

The largest benefit of a DRIP is the compounding that occurs in an investor’s portfolio. Dividends are paid on a per-share basis. Reinvesting their dividends allows an investor to buy more shares which in turn increases the amount of their dividend. And because most DRIPs allow investors to reinvest their dividends without a commission, the total return of an investor’s portfolio can grow significantly. Many DRIPs also allow investors to add additional cash for an even greater benefit.

Perhaps the one negative to a DRIP is that the shares are not as liquid as shares that are purchased on an exchange. When it comes time to sell, it could take days or weeks for investors to get their money. Also, investors should be aware that the reinvested dividends are still considered taxable income unless they are in a tax-advantaged account such as an IRA.

Introduction

Any investor who owns stocks is likely to own at least a few dividend-paying equities. Dividend stocks provide a regular source of income. But many investors may not need the cash right away, or they may not see a better investment option for that cash at the moment. Other investors with a lower risk tolerance may be looking for a long-term, buy-and-hold strategy that can increase their total return.

This is where investors can look at dividend reinvestment plans (also known as DRIPs). These plans allow investors to automatically use their dividend payments as additional cash to buy shares of the underlying company. In this article, we’ll take a deep dive into dividend reinvestment plans. We’ll define what they are and how they work. We’ll also review the benefits and disadvantages of participating in a DRIP. We’ll close the article by giving you a few tips for things you can look for when choosing a good DRIP plan.

What is a dividend reinvestment plan?

A dividend reinvestment plan (DRIP) is a program that gives investors the opportunity to reinvest their cash dividends. When they sign up for a DRIP, the investor can choose to use all or some (either as a dollar amount or percentage) of their dividend payments into the purchase of additional, or fractional, shares of the company’s stock. DRIPs are executed on the dividend payment date. Investors must be a shareholder of record by the ex-dividend date in order to reinvest their shares. Currently, about 650 publicly traded companies and about 500 closed-end funds offer DRIP programs.

How does a dividend reinvestment plan work?

Typically, a company will assign an investor to a transfer agent. The transfer agent is an entity that is hired by the company to administer its dividend reinvestment plan. In some cases, an investor may be able to purchase their initial shares directly from the company. Every company has specific rules that govern the minimum requirements for eligibility into a dividend reinvestment plan. Some companies may require an investor to own as little as one share to participate in the DRIP; others may require a higher number of shares. Yet other companies may assign a dollar amount (e.g. $250) as opposed to share volume.

After that, there’s nothing that an investor has to do. The dividends are automatically reinvested on whatever schedule a company pays out its dividend. For example, if a company issues a quarterly dividend, an investor would purchase new shares, or fractional shares, every 90 days.

For example, Coca-Cola (NYSE:KO) has a share price of $55.77 and pays a dividend yield of 2.87%. If an investor held 100 shares they would have an investment of $5,577. With a 2.87% yield, they would be scheduled to receive approximately $40 every quarter. This would mean that assuming the stock price and yield stayed the same, they would be purchasing almost three additional shares per year. 

What are the benefits of a DRIP?

Perhaps the most compelling benefit to a DRIP is the compounding that occurs. In 1985, Money magazine provided this example of the benefits of compounding. If an investor had bought 100 shares of AT&T (NYSE:T), they would have paid $1,950. The company was paying a 6.2% dividend yield. Five years later, investors who took their dividends in cash would have seen their shares worth $4,550. However, an investor who reinvested the dividends the investor would have seen their share volume increase to 124 shares that would have been worth $5,624. Compounding is even more beneficial when the company increases its dividend. This allows shareholders to receive a higher amount to reinvest which in turn can be used to purchase more shares. Over time, this strategy increases the total return potential of the investment.

Another benefit is that once an investor is enrolled in a DRIP program, most plans allow them to make voluntary cash payments directly into the plan. In some cases, investors can pay as little as $10 a month which makes it a great option for investors with smaller portfolios. As with the reinvested shares, there is typically no commission or just a nominal fee on these purchases. The shares, or partial shares, are also purchased in many cases at a discount to the current share price.

Are there negatives to owning a DRIP?

Compared to the advantages of a DRIP, these negatives are more like inconveniences. Nevertheless, two things investors may be concerned about are the reduced liquidity of their shares and the fact that any dividends (even those that are reinvested) are taxable. As mentioned above, shares of a DRIP program are bought and sold through the company. This means that when it’s time to sell shares, investors may have to wait several weeks before receiving their money.

Why do companies offer DRIPs?

Dividend-paying companies are typically in the mature phase of their business cycle. The capital they receive from investors via a DRIP plan can provide useful cash for funding various projects. Companies also realize that investors who take part in a DRIP program are less likely to sell their shares when the stock declines. This is due, in part, to the fact that many investors who take advantage of DRIP programs are buy-and-hold investors who value the significance of a dividend to the long-term growth of their portfolio. However, this may also be because, as mentioned above, shares within a DRIP are not as easy to sell as shares that the investor would purchase through a broker or exchange. Because they can only be redeemed by the company, investors are likely to hold them longer.

How do you select a dividend reinvestment plan?

Although there are many reasons to participate in a dividend reinvestment plan, not all DRIPs are the same. In addition to looking at the company’s fundamentals, investors should look at the company’s prospectus for the answer to these questions.

  1. Does the stock have a solid history of increasing their dividend? Since one of the largest benefits of a DRIP is compounding, companies that increase their dividend are the best choices.
  2. Does the company allow investors to add additional money into the plan? If they do, be sure to find out what the minimum and maximum contribution limits.
  3. Does the company allow you to purchase shares at a discounted price? The combination of purchasing shares at a reduced price plus the absence of commissions can make a significant impact on the total return over time.
  4. Does the company allow partial reinvestments? Income investors may have a desire to still receive a part of their dividend in cash.

Does a dividend reinvestment plan dilute shareholder value?

When a company issues new shares, as in a secondary offering, they are issuing common shares. These add to their outstanding shares which can push the price per share lower and affect ratios such as the price/earnings ratio and even their market capitalization. However, in a DRIP plan, investors are not buying stock off an exchange. They are buying the stock directly from the company’s treasury stock. Treasury stock is stock that the company has left on reserve. Perhaps they are shares that were not sold at the company’s initial public offering (IPO) or they can be shares that the company purchased as a way of having a source of cash. Treasury shares do not have voting rights and do not count as part of a company’s outstanding shares.

The final word on dividend reinvestment plans

Reinvesting dividends has been a safe, productive way for investors to build up a stock or fund portfolio over time. In a dividend reinvestment plan, investors elect to have their regular dividend payments reinvested into the company to buy more shares, or fractional shares, of their stock. In some cases, investors may be allowed to choose to have some of their dividend sent to them as cash and the rest reinvested. The primary benefit for investors is the compounding that takes place over time. And companies that offer DRIPs appreciate the cash that they receive as investors make regular share purchases. However, some DRIPs are better than others. One of the key things that investors should look for is companies that have a solid history of increasing their dividends. The combination of an increasing dividend and regular compounding can have a significant impact on the total return inside a portfolio. 

Companies Mentioned in This Article

CompanyCurrent
Price
Price
Change
Dividend
Yield
P/E
Ratio
Consensus
Rating
Consensus
Price Target
The Coca-Cola (KO)$54.45+1.1%2.94%26.18Hold$54.79
AT&T (T)$38.13-0.1%5.35%10.83Buy$38.28

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