Most investments have a growth component, an income component or a combination of the two.
Growth stocks focus more on reinvesting their earnings back into the company with investors focusing more on the capital appreciation of the stock price. Dividend-paying stocks offer both a growth component and an income component.
The income from these stocks comes in the form of a dividend. A dividend is a payment made by a company to its shareholders and is a way for the company to share a portion of its earnings to the shareholders.
Many companies that pay dividends also offer a dividend reinvestment program — often referred to as a “DRIP” — that automatically uses the dividend payment to buy more shares of the company’s stock.
Stock dividends or cash dividends
Companies have the option to pay stock dividends, which effectively means shareholders receive stock of the company, but the most common type of dividend is a cash dividend.
With a cash dividend, the default is for cash to be paid into the account in which the position is held. Once the dividend is paid, the cash sits in the account — and unless it is invested right away, will not be earning anything. The DRIP program is perhaps the most efficient way to keep the dividend growing — think of it as income on income.
DRIP illustration
Let’s assume an investor purchased 200 common shares of ABC Corporation, currently trading at $200 per share. The total amount invested would be $40,000 (200 x $200). The current quarterly dividend is set at 1.15 per share.
Based on these values, when the dividend is payable, the investor would receive approximately one share of ABC Corporation ($200) plus $30 cash. After the dividend, the investor would own 201 shares.
Dollar cost averaging
The DRIP program is a way for investors to buy additional shares at various points in the market. Through the DRIP program, investors are acquiring shares at different prices when each dividend is reinvested. This helps reduce the impact of short-term market fluctuations, which can help lead to better long-term performance.
Adjusted cost
For taxable accounts, it is important to keep track of the costs at which the new units were reinvested. The cost of the original purchase plus the total value of the shares reinvested on the date of the DRIP equals the adjusted cost base.
Stock splits
When a stock has a split, this often means more shares and less cash on the DRIP. Using a two-for-one stock split as an example, you will see this is normally good for people who have the DRIP set up.
Let us continue the above example. Before the split, the investor owns 200 shares with a market value per share of $200. Total invested would be $40,000. After the split, the number of shares would double to 400, and the market value per share would decline to $100. Total invested would remain at $40,000.
The dividend itself would be lowered to 0.575 per share (half of what it was). Based on the new quantity, stock price, and dividend amount, the investor would receive two shares of ABC Corporation (2 x $100) and $30 cash (400 shares x 0.575). After the split and dividend, the investor would own 402 shares.
Tax effect
Although the investor above may have requested that their dividends be reinvested, the dividend income will still be considered income for taxable accounts in the year the dividend was declared.
Investors will receive the applicable taxation slips and should ensure they have sufficient cash on hand at the end of the year to pay any tax liability. DRIPs in an RRSP account are ideal as any income is deferred and is not taxed immediately.
Fractional shares
Unlike mutual funds, it is not possible to have fractional shares of common shares. The illustration above highlights that the fractional portion (less than the amount to purchase a whole share) is paid as cash into the investment account.
Stock splits are generally a good thing for individuals that have the DRIP program. Share prices are generally reduced, resulting in a greater portion of the dividend being reinvested.
Discount to shares
Not all companies pay a DRIP. Of those companies that offer a DRIP, some of those may offer a discount on the share price of the amount reinvested. These discounts typically range from one to five percent. How the discount is calculated can change for each company that offers it.
It is not uncommon for a stock to have a discount in the past and then remove the discount. It is often dependent on the corporation’s need for capital.
Position size
Investors should take care to monitor their position sizes. Investors may find over time that certain positions that are set up with a DRIP may become overweight within their overall portfolio.
This may be a good time to rebalance the portfolio by reducing the holding and switching to another name. Alternatively, if a person has charitable intentions, they could donate some of the shares as a form of rebalancing, assuming the position is held in a non-registered account.
Cancellation
A DRIP can easily be cancelled. An investor may want to cancel a DRIP when they begin to require income from their investments. Setting up a drip and cancelling a DRIP is very easy and can be done at any time.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Senior Wealth Advisor with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138.
