Definition: A dividend reinvestment plan (DRIP) is an investment strategy in which investors reinvest their cash dividends in the company through the purchase of additional stocks on the dividend payment date.
What Does Dividend Reinvestment Plan Mean?
What is the definition of dividend reinvestment plan? Actually, a dividend reinvestment plan generates a compounding interest that allows investors to purchase additional shares when a sufficient amount of money is accrued. Investors who enroll in a DRIP automatically purchase the additional shares on the dividend payment date, but they are not receiving any cash dividend.
The key advantage for investors is that they increase the value of their investment with compounding interest. Furthermore, the additional shares are purchased without commission and are significantly discounted with respect to stock price. The company sells more shares, thus increasing the shareholder equity and maintains the certainty that DRIP investors will not sell their shares massively in the case of a market downturn. DRIPs do allow reinvestments for less than $10.
Let’s look at an example.
Carl owns 250 shares of a consumer products company that currently trade at $59. The company declares an annualized dividend of $3.00 per share and Carl receives $0.75 per share each quarter, which is $187.5 per quarter.
Carl considers enrolling in the company dividend reinvestment plan to take advantage of the additional share that he will be able to purchase with his dividends. His wife disagrees, thinking that it is better to receive $187.5 every three months than having additional shares that may even decline in price in the long run.
Carl follows his instinct and enrolls in the firm’s DRIP, thus giving up the $187.5 per quarter. On the dividend payment date, Carl automatically purchases $187.5 / $59 = $3.18 shares. In doing so, Carl owns 253.18 shares, and the next quarter, he will reinvest $189.89 to the company DRIP.
Like Carl, many investors prefer to gain additional equity in a company they trust rather than receive cash dividends.
Define Dividend Reinvestment Plan: DRIP is a method of investing all dividends back into securities when they are received.