Dividends do not always have to result in regular cash payments.
Many companies offer DRIPs (Dividend ReInvestment Programs) that
use the funds from dividends to automatically purchase more shares
of stock, at little to no cost to the investor.
Sure, investors can do the reinvestment themselves in their
brokerage accounts after receiving cash dividends, but the
transaction fees associated with share purchases can be a drag on
one's returns. That's why companies have created DRIP plans: to
make reinvestment much cheaper and simpler.
As you probably know by now, DRIP is an acronym for Dividend
ReInvestment Plan. This means that an investor's dividend is
reinvested in the company with the purchase of additional shares of
stock, rather than receiving a cash dividend payout. So instead of
receiving a quarterly or monthly dividend payment, the party
running the DRIP (the company, transfer agent, or brokerage firm)
uses the money to buy additional stock in the name of the
How DRIPs Work
Many companies operate their own dividend reinvestment plans.
Rather than purchase stock on a secondary market, such as the New
York Stock Exchange or NASDAQ, common stock is bought directly from
a company's share reserve. Once the direct stock is purchased
investors then have the option to enroll in the dividend
reinvestment plan with the company to build up a holding of more
shares. Companies do this directly or, more commonly, through a
third party called a transfer agent that handles investor
relations. Companies like Coca Cola (
), Kellogg (
), Colgate-Palmolive (
), Microsoft (
), and Johnson & Johnson (
) participate in direct purchasing and dividend reinvestment plans
with transfer agents.
Usually these direct purchase and reinvestment programs allow
investors to buy partial stock in a company with their dividend.
For instance, if a $10 stock that pays a $1 dividend is in a DRIP
then that $1 will be reinvested to purchase one tenth of a share.
This is a convenient way for an investor to start off with a
limited number of shares that can build up over a long term period.
Also, many companies' DRIPs allow for an additional cash purchase
of more shares directly from the company at discounted rates.
Not all companies have direct DRIP programs, however many
brokerage firms fill this void by also offering their own DRIPs
through purchase of stock in the secondary markets. The brokerage
run DRIPs operate much like company and transfer agent programs,
sometimes with little to no brokerage commission fees for the
transactions of buying the shares with the reinvested dividends.
However, investors do not have the advantage of optional cash
purchases and partial share purchase in brokerage-run DRIPs.
Brokerages may also charge higher fees than company-run DRIPs, so
be sure to ask your broker before enrolling.
Since the purchases within DRIPs are done automatically, the
price paid for the shares through the dividend reinvestment is
determined by an average costs of the share price over the given
time period of ownership of stock. This system is in place so an
investor does not pay for the stock at its highest or lowest
DRIPs are very beneficial to help build up wealth if the company
has substantial gains over time. For example if you had $2,000
invested in Pepsi in 1980, that would be worth more than $150,000
by the end of 2004. You would have started with 80 shares, but by
reinvesting dividends, you'd now have 2,800 shares. The opposite is
also true, if a company goes under then an investor will lose the
money reinvested, never seeing the benefits of the dividend
payouts. This is the risk and reward basis of investing. Investors
need to always keep the pulse of the company that they are invested
in to make sure they come out on top.
Other Issues with DRIPs
There are a few issues that need to be considered when thinking
about investing in a DRIP. If an investor does not need the cash
dividend a company pays immediately, then a DRIP is acceptable
alternative to traditional dividends. However, if a steady dividend
payment is needed as a source of income, then a DRIP is not an
efficient way to manage dividends. DRIPs are a way to build up
additional shares over time for a potential payoff in higher
capital gains. Investors also need to be aware that the dividends
that are reinvested are still seen as a source of income and
therefore taxable. That's right - just because you decide to
automatically reinvest the dividends, never receiving any cash,
Uncle Sam still gets his cut.
Also, depending on what kinds of DRIPs an investor is involved
with, it can be hard to track all of the transactions and purchases
that have occurred over the years. The DRIP information could be
spread out over several companies,transfer agents, or brokers,
rather than in a single online brokerage account file. Extensive
records need to be kept by an investor to maintain the proper
information to help with income and tax related questions that
might come about down the road. Keeping track of these records can
be time consuming, or costly if done by an outside source such as
an accountant. More problems could arise if the DRIP is with a
company that is merged, sold, or involved in restructuring that can
bring uncertainty to investors.
Shares bought in DRIPs are usually not easy to liquidate. Many
times investors can not immediately sell at market price. It is not
as easy as just calling a broker or hitting a button. Investors
need to take into consideration the time it might take to sell off
shares and at the price at which the sale will take place.
The Bottom Line
DRIPs are a nice alternative to the traditional dividend cash
payout. However, an investor needs to be ready to put in the
research and work to determine if a DRIP is the optimal investment
strategy. DRIP investing can bring a change of pace and potential
diversification to a portfolio, but it can result confusion and
high costs if not properly managed. An investor just needs to take
into account their needs and expectations of their investments to
determine if a dividend reinvestment plan is right for them.
Be sure to visit our complete recommended list of the
Best Dividend Stocks
, as well as a detailed explanation of
our ratings system here