Got a Dividend Reinvestment Plan Letter? Understand what it means here!

It is hard to find a blog now days not quoting or idolising Warren Buffet. A series of quotes and a general investment philosophy are becoming investor folklore. The reason for this is pretty simple, he has been the best at what he is done for a long time. He uses a compounding return strategy where the bulk of his income is reinvested rather than spent on luxury yachts and Nutri Bullets. One of the most famous facts about the great Mr Buffet is that his company, Berkshire Hathaway has never paid a dividend, in its 50 year history.

That there is the sentiment which is seeing more and more small time investors here in Australia turning to a dividend reinvestment plan (or a DRIP). You may have received letters from companies you have invested in offering you the chance to participate in a DRIP, and you may have in a confused state thrown it aside. Well today I am going to tell you all about DRIPs, so you can decide if it is right for you.

Firstly, in simple terms a DRIP gives investors the chance to forego the dividend payment, in lieu of payment in dividends. Some will give you the chance to give a percentage to payment in dividends and another chunk in cash, or you can commit 100% one way or another. Below shows how it works in practice.

You own 600 shares, at $8.00 a pop. Company XYZ has declared a dividend of $0.50 per share. You could then elect to collect a tidy dividend payment of $300. The DRIP however would allow you to reinvest that $300 back into shares, where the company would assign you 38 shares free of brokerage fees (depending on the agreement, a discount to the $8 price may apply, meaning the 38 could be higher).

So why do this? There are a few benefits of undertaking this option. The first call out is mentioned above, you get shares free of brokerage costs and often at a discount, hence this is why it appeals to the smaller retail investors like you and I. Furthermore, the benefit to this option gives you a ‘set and forget’ type operation for long term orientated investors. This strategy will give you that compounded growth I have talked about here previously.

Now of course there are factors you need to consider before you make your decision. You have to pay tax on these dividends regardless of whether they are paid in the form or cash or dividends, and then pay capital gains on all shares that you purchase/obtain. This process can make the accounting fairly complex and messy, but you can hire an accountant to look after that side of it. The last key one to consider is that the transition from dividend cash to share is calculated to the value of the share at a particular time, meaning you don’t make the call to capitalise on a cycle, and/or could end up paying an inflated price.

The bottom line here comes down to your individual strategy. Long terms investors trying to create a honey pot for retirement are attracted to a DRIP, as the goal is compound growth and keeping fees low. It is important to be confident any company that you enter into a DRIP with presents a good growth outlook.

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