What Is a Drip?
The word "DRIP" is an acronym for dividend reinvestment plan, but DRIP also happens to describe the way the plan works. With DRIPs, the cash dividends that an investor receives from a company are reinvested to purchase more stock, making the investment in the company grow little by little.
- A DRIP is a dividend reinvestment plan whereby cash dividends are reinvested to purchase more stock in the company.
- DRIPs use a technique called dollar-cost averaging intended to average out the price at which you buy stock as it moves up or down.
- DRIPs help investors accumulate additional shares at a lower cost since there are no commissions or brokerage fees.
How DRIPs Work
A dividend is a reward to shareholders, which can come in the form of a cash payment that is paid via a check or a direct deposit to investors. DRIPs allow investors the choice to reinvest the cash dividend and buy shares of the company's stock.
However, the shares are bought from the companies directly. Many companies offer shareholders the option to reinvest the cash amount of issued dividends into additional shares through a DRIP. Since these shares usually come from the company’s own reserve, they are not offered through the stock exchanges.
The "dripping" of dividends is not limited to whole shares, which makes these plans somewhat unique. The corporation keeps detailed records of share ownership percentages.
For example, let's say that the TSJ Sports Conglomerate paid a $10 dividend on a stock that traded at $100 per share. Every time there was a dividend payment, investors within the DRIP plan would receive one-tenth of a share.
Benefits of DRIPs
DRIPs offer a number of benefits for both the investors buying shares with their cash dividends and the companies offering DRIP programs.
Benefits to Investors
DRIPs use a technique called dollar-cost averaging intended to average out the price at which you buy stock as it moves up or down over a long period. You are never buying the stock right at its peak or at its low with dollar-cost averaging.
Company-operated DRIPS are popular with shareholders as a lower-cost option to accumulate additional shares. There are often no commissions or brokerage fees involved. Many companies offer shares at a discount through their DRIP ranging from 3 to 5 percent off the current share price.
The price discount combined with no trading commissions allow investors to lower their cost basis for owning a company's shares. As a result, DRIPs can help investors save money on buying additional shares of stock versus had they bought them on the open market.
Benefits to Companies
Companies that offer DRIP programs receive investment dollars or capital from shareholders. Companies can use that capital to reinvest back into the company.
Shareholders or investors that are part of a company's DRIP program are less likely to sell their shares if the company has one bad earnings report or if the overall market declines. In other words, the investors that are engaged in the DRIP program are typically long-term investors in the company.
It's important to note that the cash dividends that are reinvested into DRIPs are still considered taxable income by the Internal Revenue Service (IRS) and must be reported. Please consult a tax professional for the specific tax ramifications for your situation.
Also, when investors who purchased shares via a DRIP program want to sell their shares, they must sell them back to the company directly. In other words, the shares are not sold on the open market via a broker. Instead, a request to sell the shares must be made with the company, whereby the company will, in turn, redeem the shares at the prevailing stock price.