If you own shares in ASX companies that pay dividends, you have several options for using this new source of income.
You can spend it straight away, add it to your holiday or emergency savings, or even put it towards another investment. Some companies allow you to automatically reinvest your dividends in new shares through a dividend reinvestment plan, or DRP.
In this article, we will examine DRPs in more detail and explain the benefits they can provide to your portfolio.
First, some background on dividends
Dividends enable companies to distribute some of their earnings to their shareholders. When a company earns a profit, it can use that money in a few different ways.
It could repay its outstanding debts, reinvest the money into growing its business, or return some of the money to its shareholders as cash payments called dividends.
What is a dividend reinvestment plan (DRP)?
Companies that offer DRP programs allow their shareholders to elect to automatically reinvest all or a portion of their cash dividends into new shares in the company. So, instead of a cash payment, you will see an increase in the size of your shareholding in the company. It will be equivalent to the amount of money you would have otherwise received as your dividend.
Depending on the company and the terms of the plan, these shares may even be issued at a discount to their current market price.
Plenty of ASX companies offer DRPs, including mining giant BHP Group Ltd (ASX: BHP), big four bank Commonwealth Bank of Australia (ASX: CBA) and leading biotech CSL Limited (ASX: CSL).
Many exchange-traded funds (ETFs) and Australian real estate investment trusts (REITs) offer similar programs. They also allow unitholders the option to automatically reinvest a portion of their regular cash distributions into new units in the fund.
How does a DRP work?
When you become a shareholder in a company or fund that offers a DRP, the company will typically reach out to you to ask if you would like to participate in the plan. Most companies that offer a DRP will also provide details of the plan on their website, where you can download a copy of the application form. Then, it's as simple as completing the form to opt into the plan.
Shareholders can generally select whether they want full or partial participation in the plan. Full participation means that dividends payable on all shares you hold in the company (or fund) at each dividend record date are subject to the plan.
Partial participation means you specify how many of your shares you would like to be subject to the plan. The dividends received on this number of shares will be reinvested in the company, while the dividends on your remaining shares will be paid to you in cash via a direct bank deposit.
What are the benefits of a DRP?
Shareholders can gain many potential benefits from participating in a DRP.
Firstly, you are still entitled to those juicy franking credits on any dividends reinvested in a DRP program. Franking credits can offset the income tax you have to pay each year.
Not only that, but when you reinvest your dividends automatically in a DRP, you don't have to pay any of the typical fees associated with executing the trade, like brokerage, commission or other transaction costs.
A DRP can even provide a hedge against inflation. Reinvesting your dividends into new shares means the purchasing power of your money isn't being eroded. On the other hand, if you take your dividends as cash and leave them sitting in your bank account — particularly in an inflationary economy — they can lose their value over time as goods and services generally become more expensive to buy.
Compounding: It's a kind of magic
And if all that wasn't good enough, the single best reason to consider signing up to a DRP is to benefit from the miracle of compounding. This is a fancy way of saying that you earn interest on your interest. However, its incredible wealth-generating power is best illustrated by a simple example.
Let's say you took out a $100 term deposit that paid 10% in interest annually. Suppose you held this deposit for 10 years but withdrew your 10% interest payment each year. At the end of the 10 years, you would still have your original $100 investment. You would have also earned $100 in interest: 10 years x the $10 in interest (or 10% of your $100 balance) that you withdrew each year.
However, let's instead assume that you left the interest you earned each year in the term deposit. Each year, the interest paid is added to your ending balance, and the next 10% interest payment now accrues on the higher balance. For example, at the end of the first year, you are paid $10, which is then added to your ending balance. In the second year, your interest payment increases to $11 (10% x $110). Then in the third year, the interest payment increases again to $12.10 (10% x $121), and so on.
And a matter of time
This time around, at the end of the 10 years, you would be sitting on an ending balance of $259.37. This means you would have increased your overall return by almost 30% by simply leaving your money in the term deposit to compound over time.
The longer the time frame, the greater the benefit you gain from compounding. If we used the same term deposit example but increased the timeframe to 20 years, you would have an ending balance of $672.75. If it were 50 years, you'd have $11,739.09!
DRPs can provide the same benefits for your share portfolio. Setting up a DRP and simply leaving your shares to compound over time can greatly magnify your returns.
Foolish takeaway
DRPs offer many potential benefits for investors. They are relatively easy to set up and can significantly magnify your returns over time through the magic of compounding.
DRPs aren't for everyone, and you should consider your investing goals and income needs before setting up a DRP. Investors who rely on their portfolios as a revenue stream –like some retirees — may not wish to participate in a DRP and prefer to continue receiving their dividends as cash.
However, younger investors, or those with a longer investment time horizon, may find that DRPs provide an effective way to grow their wealth over time.
