A Divident Reinvestment Plan (DRIP) is a program or plan that allows you to buy stock directly from that company. You will receive dividends as you normally would, with the exception that rather than receiving a cash dividend, the company will give you stock of an equal value to the cash that you would have received.
Dividends are basically returns from an investment. Investors must choose to either consume (spend) the dividend payment or to invest it in the same investment or some other investment. The term dividend reinvestment generally refers to dividends being invested back into the investment from which they were earned.
The benefits derived from this strategy can be quite impressive. If an investor chooses to consume dividends, the principle will have grown only from the increased price of the stock. For example, assume a stock selling for $30 pays a dividend of $2.00 at the end of each year and will appreciate over time at a compound rate of 10%. The following table illustrates the results of consuming or reinvesting the dividends after 10 years.
|Consuming Dividends ||Reinvesting Dividends |
|PV = ||$30.00 ||PV = ||$30.00 |
|n = ||10 years ||n = ||10 years |
|i = ||10% ||i = ||10% |
|PMT = ||$0.00 ||PMT = ||$2.00 |
|FV = ||$77.81 ||FV = ||$109.69 |
The table above illustrates that if you purchase this stock on "Day 0" for $30, you would have 1 share of stock, you would receive your $2 dividend payment every year and still have that same share of stock, although at a 10% higher price. Reinvesting those dividends in new shares of stock would give you 1.41 shares of stock at the end of the 10 year period. With no reinvestment, your stock would be worth the $77.81 listed above. With the reinvestment, your 1.41 shares of stock are worth a total of $109.69, a difference of $33.87 (or 41% more).
There are a number of advantages to these programs. In many cases, you are buying the stock with no fee associated with the transaction. If you were to receive cash dividends (for example) and then turn around and buy that stock, you would pay a trading fee for that purchase. This increases the cost of your stock. Many brokers have programs where the DRIP is free of transaction costs like ETrade, Schwab and Scottrade. The true benefit to a DRIP is what is known as compounding. This is when you consistently reinvest all of the income made on an investment in order to make more and more. This is a really good illustration of how a DRIP would work and illustrates the benefits of compounding.
Looking at and thinking about a 'fictional' situation isn't a really great way to imagine this. Let's look at AEP (American Electric Power). This link is the price history including the dividend history of this stock. If you were to purchase 100 shares of this stock on January 2nd of 2007 and reinvested all of these quarterly dividends for the last 10 years, today you would have 144 shares of stock. The stock in 2007 traded at $43.53 and today trades for $62.71. Just in price appreciation alone your investment would have grown 44%. This by itself is not a stellar return, but it is in fact a fairly safe one. The reinvestment of those dividends added significantly to the value of the investment pushing the value up by 107%. The cost of the shares back in 2007 would have been $4,353 and the value with the DRIP would have grown the value to $8,998.41 and without the DRIP the value would have grown to $6,271 [for an initial purchase of 100 shares].
The image below illustrates the additional growth in value achieved using a DRIP as compared to earning the dividend and doing something else with it (like buy something).