Dividend Reinvestment Plans

Dividend reinvestment plans – helpful or harmful?

A discussion of dividend reinvestment plans, including advantages and disadvantages

Mike King

Mike King is a Fool.com.au Investment Analyst and Writer. He caught the investing bug more than a decade ago, at a time when the U.S. had invaded Iraq and fear reigned in the markets. His initial success as the markets took off encouraged his passion and thirst for knowledge. With 13 years behind him at one of Australia's largest domestic banks, Mike's passion for stocks led him to join a boutique funds management firm, where he stayed for four years. A seven-year stint in equity research at one of the largest investment banks in the world followed that, giving Mike a thirst to pursue his passion further. Mike holds a Diploma in Applied Finance and Investment and a Graduate Certificate in Financial Planning. His passion is to help retail investors invest better, and that passion was one of his primary reasons for joining The Motley Fool Australia in late 2011. Mike has written thousands of articles since joining, including for Fairfax Media, Yahoo!7, Ninemsn and has also appeared on ABC's The Business. You can see all of Mikes' holdings here

Published December 17, 2012 8:39 am AEDT

Dividend Reinvestment Plans (sometimes abbreviated to DRPs) allow shareholders to take part or all of their dividend in the form of additional shares rather than cash, with no transaction or brokerage costs

Some DRP plans offer shares at a slight discount to the share price as an additional benefit.

Advantages to the company are that instead of paying out cash, they are issuing shares, which keeps cash in the company's coffers. For example, the big four banks may only have to pay out 75% of the cash allocated for dividends, with the other 25% staying in the bank for reinvestment.

For shareholders the advantage is that when its done right, over a long period and through a holding in a solid company like Woolworths (ASX: WOW), shares can be purchased at all stages of the economic cycle, so some may be really cheap, whiles might be expensive, but over time should even out.

The decision about what to do with the dividend cash is taken out of the hands of the shareholder, so they don't need to make a decision on where to reinvest or even whether to reinvest the funds.

Of course, no matter whether you take the cash or dividends, you still have to pay tax on the 'value' you receive. (Remember, the DRP is essentially an automatic reinvestment of your dividend – saving you the hassle of receiving the cash, then buying the shares on the market.)

The disadvantages are, if the company is not a good solid company and as a worst case scenario, investors may end up with more shares in a company that goes bust, and have not received any dividends to offset the loss.

Underwritten DRPs

The Claytons dividend – It's a sneaky way of declaring a dividend, but then not paying one – a move that could be declared as 'not in the best interests of shareholders'.

The company will issue shares to fund the full dividend amount. If a shareholder chooses to participate in the DRP, then the company will issue the shares to you. If you choose to receive the cash instead, the shares will be issued to another party, and use the cash it gets from them to pay your dividend.

In other words, the company doesn't really pay out any net cash – all of the cash that's paid is returned to the company through the issue of those new shares.

When a company continues to pay underwritten dividends, your holding in the company will very quickly get diluted, if you choose to not participate in the DRP. In other words, your percentage holding of the company will shrink each time the company declares a dividend.

It's a sneaky way of declaring a dividend, but then not paying one – a move that could be declared as 'not in the best interests of shareholders'. It's best to give any company doing this, a black mark against their name – such as National Australia Bank (ASX: NAB), Bank of Queensland (ASX: BOQ), Billabong International (ASX: BBG), ANZ and Westpac in recent times.

There may be reasons for a company wishing to keep some of that money – because it has growth opportunities it needs to fund, for example – but in those circumstances, we'd rather the company simply reduce or suspend the dividend. The result is the same for the company, and fairer for shareholders.

Advantages for shareholders

It's a 'set and forget' process to continue re-investing in companies
Don't have to decide where to invest the dividend
Slice of pie, or "share of the company" remains the same
Are sometimes issued at a slight discount e.g. 5% to the current trading price, and without brokerage or transaction fees
Can take all or part of the dividend as new shares, and participation is voluntary, so shareholders can elect to participate in some years and not in others
Shares issued under the DRP rank equally with ordinary shares and can be sold as soon as they have been allocated to the shareholder.

Disadvantages for shareholders

Takes the investing decision out of your hands, and DRPs for some companies and at some periods can be a bad decision
Slice of pie can shrink, and majority shareholders can increase their holdings
Can make tax decisions difficult, when selling e.g. if significant capital gains within 12 months on shares issued under DRP, full rate of capital gains tax is payable, whereas shares purchased more than 12 months before selling are eligible for 50% discount on tax, if there's a capital gain
Can make administration difficult – tracking shares issued, cost base prices. As an example, if you hold shares in a company for 20 years and it issues dividends twice a year, you would need to keep track of 40 separate transactions for tax purposes – and that's just for one company
Companies can suspend DRPs whenever they want
Some companies will set a limit on the number of share participating e.g. Woolworths' limit is 20,000 shares.

Advantages for companies

Don't have to pay out the full dividend amount in cash
Results in an increase in invested capital

Disadvantages for companies

Administration expenses of issuing new shares and setting up a DRP account for each shareholder who participates, rather than just paying out cash
Increases the number of shares on issue, so can dilute earnings per share – a number that many companies use to calculate executive pay and bonuses.

Here's a few examples of companies that currently have active DRPs.

Woodside Petroleum (ASX: WPL) – No discount to trading price, no limit on number of shares per shareholder.

Suncorp Group (ASX: SUN) – No discount to trading price, no limit on number of shares per shareholder

ASX Limited (ASX: ASX) – No discount to trading price, no limit on number of shares per shareholder.

Origin Energy Limited (ASX: ORG) – No discount to trading price, no limit on number of shares per shareholder.

Woolworths Limited (ASX: WOW) – No discount to trading price, 20,000 limit on number of shares per shareholder.

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Motley Fool writer/analyst Mike King owns shares in Woodside and Woolworths. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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