What is a Dividend Reinvestment Plan? What are the benefits for Investors? The power of compounding can have huge benefits over a long-time horizon. Disadvantages and factors investors need to consider. Investors can increase their shareholding by reinvesting cash back into the company for additional shares with little to no effort at all.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it”
Albert Einstein’s quote regarding the power of compounding lends itself well to the concept of a dividend reinvestment plan (DRP) in that an investor is able to conveniently reinvest earnings into new shares instead of receiving the dividends in cash, to increase their investment over time.
What is a Dividend Reinvestment Plan?
If a shareholder opts into a Company’s DRP, at the time of each dividend, instead of receiving their dividend in cash, the amount is reinvested into new shares in the company. The new shares are ranked equally with existing ordinary shares and thus have the potential to generate additional earnings/dividends in the future, thus the compounding effect.
Benefits for Investors
• Convenience and ease – investors can increase their shareholding by reinvesting cash back into the company for additional shares with little to no effort at all.
• Fees – investors do pay brokerage or any additional fees for the purchase and/or administration of the new shares. Going a step further, some companies will issue shares at a discount, potentially ranging from 1% to 10%, to entice shareholders to participate.
• Carried forward amounts – only the whole number of shares are purchased under a DRP, thus any amount that would be used to purchase a fraction of a share is retained and carried forward to be added to the next dividend and subsequent purchase of additional shares.
• Dollar-cost averaging – DRPs have the ability to remove some cognitive biases and the temptation of trying to time the market as new shares are purchased automatically without factoring in if the stock is over or under-priced. While the cost of shares will vary, DRPs provide a smoothing mechanism over the long term.
• Equally ranked – shares that are issued under a DRP will rank equally with existing shares from the date of issue and are able to be traded just like an ordinary share.
• No minimum limit – there is no limit on the number of shares able to be purchased under a DRP, unlike some trading platforms which have a minimum limit, hence all investors can participate and benefit from the effect of compounding.
Power of Compounding
As noted earlier in the article, the power of compounding can have huge benefits over a long-time horizon and can be easily illustrated in the below chart which looks at the returns for the S&P/ASX Small Ordinaries Index. The cumulative return difference of ~128% over a 15-year period is caused by dividends being reinvested which are depicted by the total return, which includes dividends of the S&P/ASX Small Ordinaries vs the price return of the same index.
Now a word of warning, the performance of the price-only index (dark orange line) does not include any reinvestment of earnings generated over the ten-year period thus one needs to assume that the earnings generated and paid out to the investor were then allocated to other investments including cash. To go a step further, these investments would generate different rates of return but also incur transactional costs.
Disadvantages and factors investors need to consider
While the above sets out the benefits of a DRP, it’s worth considering the disadvantages and potential impacts.
• Capital allocation – there is flexibility in the level of participation an investor can select, either partial or full, but investors should consider allocation impacts, specifically around two key areas:
o At the company level – an investor who participates in a DRP is returning their dividend (or capital) back to the business for management to reinvest into their existing strategy. Hence investors must be comfortable with a management’s team capital allocation decisions.
o Investor’s portfolio – a DRP will increase the number of shares held in a particular investment thus changing the portfolio mix and weighting could alter return and risk attributes.
• Timing – investors have little control over the timing of dividends and the subsequent purchase of shares; hence the reinvestment could take place while the stock is over or undervalued.
• Dilution – this won’t apply to DRP participants but a DRP can have a dilutive impact as companies generally issue new shares, thus increasing the total number of shares on issue.
One of the nuances of DRPs is the method used in determining the price at which shares are allotted to shareholders which are at the discretion of the company’s board and depending on approach and method, can have a significant factor, some of the most common approaches used in determining a price used for DRPs are:
• Volume weighted average price (VWAP) from a certain period of trading days, generally 3-7 days post the record or ex-dividend date. Worth noting some companies' calculation period was as long as 20 days.
• Average weighted cost of shares purchased by the company on-market. One notable benefit of this approach is that shares are purchased on market to remove any dilutive impact.
• Generally, for LICs/LITs, the price is determined by the lesser of the most recent NTA or the average price of all shares acquired on the ASX.
While dividends are beneficial and can contribute to meeting a shareholder’s long-term objectives, a reinvestment plan can provide a convenient and free opportunity to compound capital into the future.