Dividend Reinvestment Is a Way to Buy Stock without Commission - dummies

Dividend Reinvestment Is a Way to Buy Stock without Commission

By Paul Mladjenovic

Dividend reinvestment plans (DRPs or DRIPs) are great for small investors and people who are truly long-term investors in a particular stock. A company may offer a DRP to allow investors to accumulate more shares of its stock without paying commissions.

A DRP has two primary advantages:

  • Compounding: The dividends (cash payments to shareholders) get reinvested and give you the opportunity to buy more stock.

  • Optional cash payments (OCPs): Most DRPs give participants the ability to make investments through the plan for the purpose of purchasing more stock, usually with no commissions. The OCP minimum for some DRPs is as little as $25 (or even nothing).

Here are the requirements to be in a DRP:

  • You must already be a stockholder of that particular stock.

  • The stock must be paying dividends.

Compounding with dividend reinvestment

Dividends are reinvested, offering a form of compounding for the small investor. Dividends buy more shares, in turn generating more dividends. Usually, the dividends don’t buy entire shares but fractional ones.

For example, say that you own 20 shares of Fraction Corp. at $10 per share for a total value of $200. Fraction Corp.’s annual dividend is $1, meaning that a quarterly dividend of 25 cents is issued every three months.

If this stock is in the DRP, the 20 shares generate a $5 dividend payout in the first quarter (20 shares × 25 cents), and this amount is applied to the stock purchase as soon as it’s credited to the DRP account (buying you half of a share).

If you presume for this example that the stock price doesn’t change, the DRP has 20.5 total shares valued at $205 (20.5 shares × $10 per share). The dividend payout isn’t enough to buy an entire share, so it buys a fractional share and credits that to the account.

Now say that three months pass and that no other shares have been acquired since your prior dividend payout. Fraction Corp. issues another quarterly dividend for 25 cents per share. Now what?

  • The original 20 shares generate a $5 dividend payout.

  • The 0.5, or half share, in the account generates a 12.5-cent dividend (half the dividend of a full share because it’s only half a share).

  • The total dividend payout is $5.125 (rounded to $5.13), and the new total of shares in the account is 21.01 (the former 20.5 shares plus 0.513 share purchased by the dividend payout and rounded off; the 0.513 fraction was gained by the cash from the dividends). Full shares generate full dividends, and fractional shares generate fractional dividends.

To illustrate the point easily, the preceding example uses a price that doesn’t fluctuate. In reality, stock in a DRP acts like any other stock — the share price changes constantly. Every time the DRP makes a stock purchase, whether it’s monthly or quarterly, the purchase price will likely be different.

Optional cash payments in dividend reinvestment plans

Most DRPs (unless they’re run by a broker) give the participant the opportunity to make optional cash payments (OCPs), which are payments you send in to purchase more stock in the DRP.

DRPs usually establish a minimum and a maximum payment. The minimum is typically very modest, such as $25 or $50. A few plans even have no minimum. This feature makes it very affordable to regularly invest modest amounts and build up a sizable portfolio of stock in a short period of time, unencumbered by commissions.

DRPs also have a maximum investment limitation, such as specifying that DRP participants can’t invest more than $10,000 per year. For most investors, the maximum isn’t a problem because few would typically invest that much anyway. However, consult with the plan’s administrator, because all plans are a little different.

OCPs are probably the most advantageous aspect of a DRP. If you can invest $25 to $50 per month consistently, year after year, at no (or little) cost, you may find that doing so is a superb way to build wealth. OCPs work well with dollar cost averaging (DCA).