What is a 'Dividend Reinvestment Plan - DRIP'
A dividend reinvestment plan (DRIP) is offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date. A DRIP is an excellent way to increase the value of an investment. Most DRIPs allow investors to buy shares commission-free and at a significant discount to the current share price, and do not allow reinvestments much lower than $10. This term is sometimes abbreviated as "DRP."
BREAKING DOWN 'Dividend Reinvestment Plan - DRIP'
Normally, when dividends are paid, they are received by shareholders as a check or a direct deposit into their bank account. As of 2016, many companies offer shareholders the option of reinvesting the amount of the dividend by purchasing additional shares through a DRIP. Because shares purchased through a DRIP typically come from the company’s own reserve, they are not marketable through the stock exchanges. Shares must be redeemed directly through the company. If a company does not offer a DRIP, one can be set up through a brokerage firm. Many brokers allow dividend payments to be reinvested in the shares of any stock held in an investment account. Although the dividends are not actually received by the shareholder, they still need to be reported as taxable income.
There are several advantages of purchasing shares through a DRIP. DRIPS offer shareholders a way to accumulate more shares without having to pay a commission. Many companies offer shares at a discount through their DRIP from 1 to 10% off the current share price. Between no commissions and a price discount, the cost basis for owning the shares can be significantly lower than if the shares were purchased on the open market. Long term, the biggest advantage is the effect of automatic reinvestment on the compounding of returns. When dividends are increased, shareholders receive an increasing amount on each share they own, which can also purchase a larger number of shares. Over time, this increases the total return potential of the investment. Because more shares can be purchased whenever the stock price decreases, the long-term potential for bigger gains is increased.
Dividend-paying companies also benefit from DRIPs in a couple of ways. First, when shares are purchased from the company for a DRIP, it creates more capital for the company to use. Second, shareholders who participate in a DRIP are less likely to sell their shares when the stock market declines. One reason is the shares are not as liquid as shares purchased on the open market. Another reason is DRIP participants can more easily recognize the role their dividends play in the long-term growth of their investment.