Companies may decide to pay a portion of their earnings back to shareholders in the form a dividend. This dividend can be paid out in cash or shares. The payment of shares is known as a dividend reinvestment plan (DRP). It is not compulsory for companies to pay out dividends as they may decide to keep the funds within the company as retained earnings. As an investor you may be given a choice to take up your dividend as a DRP. Below are some of the advantages and disadvantages of DRP.
What is a DRP?
A dividend reinvestment plan is when a company allows shareholders to take up the option to receive their dividend in the form of shares instead of cash.
Why Do Companies Offer DRP?
Companies may decide to offer DRP to keep cash within the company. Hence the decision to offer DRP will depend on whether they need cash for future projects in the future. They will offer a DRP to limit the cash flow out of the company.
When companies offer DRPs, the investor can take up additional shares free of any brokerage.
Shares offered in a DRP can be brought at a discount to the market price, these discounts range between 1 percent to 10 percent of the market price. Discounts in some DRPs may apply to optional cash purchases as well.
DRP purchases can be set up so the investor does not have to think about it. Once the DRP option is elected, this is automatically processed for the investor. This means that it forces them to buy stock on a regular basis with little effort. It is a convenient way to invest at a discount in a particular company regularly in small increments over a long period of time. This can also be forced savings as the investor does not see the cash and not be tempted to spend it as it automatically reinvested into the stock.
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The returns are compounded with DRPs as shares are reinvested to generate further shares.
Shareholders who participate in DRP end up owning more of the business over time where as other investors have their ownership interest diluted.
Administration can be a headache as investors will need to be diligent with their tax records as DRPs will have a different cost base for each parcel for people who wants to sell their shares.
Concentration of Holdings
As DRPs can be a set and forget exercise it can encourage the investor not to diversify. This can lead to the investor to be heavily weighted in a stock in their portfolio. If the investor received cash instead, they would have the funds and could diversify their portfolio by purchasing other stocks.
Not Suitable to Short Term Investors
DRPs are not suitable for the short-term investor as the purchase of the shares on the stock market would be faster than obtaining them from a DRP. It would be better for a short-term investor to take the dividend in cash and then buy more shares on the market following a significant correct than to take the discount offered by the DRP.
No Control of Price and Time
When you participate in a DRP, the purchase price is set by the company and investors also have no control of when they buy the shares because that is decided by the company as well. Hence investors may not be buying the shares at valuations that they find unacceptable.
No Income Stream
DRPs may not be suitable to retired investors as they may need income from their portfolio to support their living expenses. Investors are sacrificing cash in exchange for shares in a DRP so it may be suited to investors who do not need cash immediately.
Lauren Hua is a private client adviser at Fairmont Equities.
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