Dividend Reinvestment Plans: A Simple Guide for Long-Term Investors

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it” – Albert Einstein

Einstein’s quote regarding the power of compounding lends itself well to the concept of a Dividend Reinvestment Plan (“DRP”) in that a shareholder 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 rank equally with existing ordinary shares and thus have the potential to generate additional earnings/dividends in the future, thus the compounding effect.

Common Benefits of a DRP for Shareholder

Set out below are some of the more common benefits associated with a DRP, but it is worth noting that not all DRPs are the same; rules vary between companies, particularly around factors such as pricing, discounts, rounding and treatment of residual cash.

• Convenience and ease – shareholders can increase their shareholding by reinvesting cash back into the company for additional shares with little to no effort at all.
• No brokerage or transaction fees – shareholders do not need to pay brokerage or any additional fees for the purchase and/or administration of new shares issued through a DRP.
• Acquiring shares at a discount – Some companies will issue the DRP shares at a discount to the current share price, potentially ranging from 1% to 10%, to entice shareholders to participate. Other companies (such as the NAOS LICs) may acquire shares on-market at a discount to the net tangible assets of the Company if it’s not value destructive for shareholders.
• 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 whether 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 shareholders can participate and benefit from the effect of compounding.
• Voluntary and flexible – shareholders have the choice to participate in a DRP or not, and the election to participate in a DRP or otherwise receive a cash dividend can be changed as needed to suit your needs.
• Fully automated – if you have elected to participate in a DRP, once you make that election, everything from there is fully automated. You do not have to do anything else in order to receive your shares in lieu of a dividend.
• Increases future dividend amounts – participating in a DRP facilitates a way in which you acquire more shares. Should dividends be paid by a company in the future, you will receive a higher dividend given a higher level of share ownership (ceteris paribus).
• Tax credits retained & franking credits still apply – importantly, you are still entitled to all credits that you would receive should you elect to receive the dividend in cash. From a franking credit standpoint, there is no difference whether you elect cash dividends or DRP.

Power of Compounding

The power of compounding can have meaningful benefits over a long-time horizon and this is illustrated in the chart below which compares two scenarios, the only difference being that one scenario elects to receive 100% of the dividends paid out in cash versus the other scenario which elects to receive 100% of the dividends as DRP. The other details are as follows:

• Initial investment = $1000
• Period of investment = 10 years
• Annual return = 10%
• Dividend yield = 5%
• Timing of dividends paid = end of year
• DRP discount price = no discount

As we can see at the end of the 10-year period, based on the abovementioned factors, the DRP election scenario produces a total return of value of investment of $4225, some $755 more than the scenario in which all dividends are paid out in cash.

When comparing these two scenarios to the original investment amount of $1000, we can see from the chart below that the difference of $755 equates to 75.5% of our original investment. Put simply, by simply choosing DRP for 100% of our dividends over the 10-year period, this alone has generated a 75.5% return on our original investment.

Now, it is worth stating that the performance of the 100% dividends paid out as cash scenario does not include any reinvestment of those dividends into other investments, thus one needs to assume that the dividends paid out were not reinvested into any other assets. To go a step further, these investments would generate different rates of return but would also incur transactional costs. Finally, whilst it is applicable in both instances, neither scenario accounts for any impact of franking credits.

Disadvantages and factors shareholders need to consider

So far in this article we have set out the common benefits of a DRP, however it’s worth considering the disadvantages and potential impacts.

Capital Allocation – there is flexibility in the level of participation a shareholder can select, either partial or full, but shareholders should consider allocation impacts, specifically around two key areas:

• At the company level – a shareholder who participates in a DRP is returning their dividend (or capital) back to the business for management to reinvest into their existing strategy. Hence shareholders must be comfortable with the management team’s capital allocation decisions.
• Shareholders’ portfolio – a DRP will increase the number of shares held in a particular investment thus changing the portfolio mix and weighting which could alter return and risk attributes.

Timing – shareholders have little control of the timing of dividends and the subsequent purchase of shares; hence the reinvestment could take place while the stock is over or undervalued.

Potential Dilution – this won’t apply to those who participate in a DRP but a DRP can have a dilutive impact as companies generally issue new shares, thus increasing the total number of shares on issue. This does not apply to a company where the DRP acquires share on-market as opposed to issuing new shares (which is the case for NAOS LICs).  

How Are DRP Share Prices Determined?

One of the nuances of a DRP is the method used to determine the price at which shares are allotted to shareholders, which is at the discretion of the company’s board. Depending on the approach taken, this can therefore significantly impact the value that shareholders derive from a DRP. Some of the most common approaches used in determining a price used for DRPs are:

• Volume Weighted Average Price (VWAP) over a set period of trading days, generally 3-7 days following the record or ex-dividend date. However, this can vary from company to company; for example, some have a calculation period as long as 20 days.
• Average weighted cost of shares purchased by the company on-market. A notable benefit of this approach is that it involves acquiring shares on-market, which removes any dilutive impact.

Summary

While dividends can play an important role in supporting a shareholder’s long-term objectives, participating in a DRP offers an efficient and cost-effective way to compound capital over time. By reinvesting dividends into additional shares, often without brokerage or transaction costs, shareholders can steadily increase their exposure to the company. Depending on the valuation of the company at the time, a DRP may also provide an opportunity to acquire shares at an attractive price. Have you considered whether electing into a company’s DRP aligns with your long-term compounding goals, and whether the benefits outweigh any potential disadvantages?