Dividends are part of the company’s earnings, paid back to its shareholders, usually in the form of cash. Why does a company do that? Usually, when a company reaches a stable stage, the rate of return that it provides does not beat risk adjusted return available in the market. At this point, re-investing profits in the company does not make sense. Therefore, the company distributes profits to investors in the form of dividend. This is known as a Dividend Reinvestment Plan, or DRIP.

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Whenever a company issues dividends, the company’s cash per share goes down. Consequently, shareholders’ investment in the company reduces as well. Actually, the price of the stock goes down by the same amount as the dividend paid per stock. Many investors might not want that and would like to stay invested. DRIP exists for such investors. So, instead of giving out cash, the company issues more stocks to the shareholders interested in the dividend reinvestment program. This way the total money invested for an investor remains the same while the number of shares held increases.

Companies usually sweeten the deal for DRIP investors by giving them a discount on the market price of the share. So it’s a win-win situation for both investors and the company. Please note that it may result into acquiring partial shares. For example if a company’s share price is $100 per share and company is issuing $10 dividend. In that case the DRIP investors will end up getting a 1/10th additional share for each share held in their account before the issuance of the dividend.

Why Dividend Reinvestment Plan?

Some of the investors may be bullish on the company’s stock. These investors would like to re-invest the cash payout instead of cashing out.. For these investors, DRIP is a convenient option. It lets the investor re-invest the cash given out as dividend.

Also companies like that because this is a good way to maintain the cash level and encourage people to stay as loyal investors. Most of the companies actually offer incentives like discounted prices, no broker commissions to investors to adopt DRIP. Small companies usually tend to offer hefty discounts to its loyal shareholders by offering as high as 20% discount on the share price from the market price.

If you think that the stock with a nice dividend yield is going to rise in the near future, DRIP is a smart option for investment. DRIP is one of the most popular means of investment for a wide variety of long term investors.

What are the Different Types of DRIP?

DRIPs are of two types: traditional and synthetic. Traditional DRIPs allow you to re-invest dividends in the company. Traditional DRIPs are offered by the companies themselves. Whereas, synthetic DRIPs are offered by Brokers. With synthetic DRIPs, you can invest your cash to buy stock in a company that did not pay you the dividends.

How to Check if A Company offers a DRIP?

Most of the established companies on the stock market offer DRIP. You should check out with the “Investor Relations” department of the company to know if it offers DRIP. Most DRIPs require you to be an existing shareholder.

Which Brokers Facilitate DRIPs?

Brokers with DRIPs allow the reinvestment of dividends into additional shares without any additional charges. However, some broker DRIPs do not allow the purchasing of fractional shares. A few of the companies that facilitate DRIPS include: E*TRADE, Vanguard, Schwab and TD Ameritrade.

While these brokers provide DRIPs, it is advised that you should read the Editorial Reviews of Stock Brokers before finalizing on a broker. By reading the reviews, you can know if a particular broker suits your needs.

What Are the Benefits of DRIP?

1. Zero Commission: The major benefit of using DRIP is that you can buy stocks without having to pay broker commission.

2. Dollar-Cost-Averaging: DRIP enables you to take benefit of dollar-cost averaging from your income through the dividends.

3. Discounted Price: Some DRIP offers stock at a discounted price as compared to the market price. Discounts can range from as little as 1% to as much as 10%.

4. Fractional Shares: DRIP allows you to purchase fractional shares. As, the dividend is relatively a small percentage of the share price, it might not be sufficient to buy a whole share. If you do not want to wait and accumulate cash until they become a whole stock, fractional shares are a good option.

What Are the Downsides of DRIPs?

1. Maintain Records: One of the major drawbacks of DRIP is that you have to maintain records of all stocks purchased. These records are needed while calculating the capital gains tax, when you sell your shares. If you regularly buy shares using DRIP, this record keeping can be burdensome.

2. Minimum Share Requirement: With some DRIPs, you must have a minimum number of shares, for you to enjoy the benefits. You should inquire with the company beforehand, concerning the share requirements for enrollment. This way there will be no surprises when the dividend is paid.

DRIPs can be beneficial for investors who are bullish on the company’s stock by re-investing their dividends. However, you should not invest for the sake of investing in a DRIP; rather technical and fundamental analysis should be the driving factors.

Punit Gupta is an entrepreneur and full time stock trader currently developing a brokerage comparison platform.

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