Thursday, March 29, 2007

Why You Should Enroll In A DRIP Plan

Recently I have been corresponding with several readers about their holdings and and in the course of our conversations, I suggested to many of them that they enroll in a DRIP plan for a certain security. Many of them did not know what they were, how they worked or how they helped their investments. So naturally, when I have a bunch of folks asking the same question, it then becomes time for a post about it.

First things first: What is a DRIP plan? It is short for "dividend re-investment plan". Now the next question you probably have is what does that mean? It means that instead of getting cash each time the company you have stock in pays a dividend, they give you more stock. What does this do for you? A couple of things
  • It allows you to acquire more stock without paying brokerage fees (commissions)
  • Keeps dividends in your account accruing, rather than being spent.
  • Increases your return on the original investment at a greater rate than had you just received them in cash (more on this below).
  • Dividends are only taxed at 15%, so compounding your returns via them vs. ordinary income reduces your tax burden.
Now, how does all this work? Lets go through an example. I will make it as simple as possible but as usual, please email me any questions. We are buying stock in ABC Corp. We buy 100 shares at $20 a share for a total investment of $2000. ABC pays an annual dividend of $1 a share (5%) that increases 10% annually. Now, for simplicity, lets assume that the price of ABC stock never changes for 10 years and stays the same as we bought it at, $20. This way we can measure the true effect of the DRIP plan.

After 10 years, the no-drip plan investment would have returned to you $1593.74 in dividends for a total return on your original $2000 investment of 79%, or a average of 7.9% annually.

Now, lets look at what a DRIP plan can do to those same results. Remember, we are now getting our dividends in stock, not cash. This means that our results are going to be compounded by the extra shares we will be receiving which we will then be receiving dividends on. I will go through the first few years and then extrapolate it out to the final result:

Year 1
Shares = 100
Dividend = $100 or 5 more shares ($100 divided by the $20 a share price)
Non-DRIP plan dividend= $100

Year 2
Shares= 105 (100 + 5 from year 1 dividend)
Dividend= $115 or 5.75 more shares ($115 divided by the $20 a share price)
Non-DRIP dividend = $110

Year 3
Shares = 110.75 (105 + 5.75)
Dividend= $134 or 6.7 more shares ($134 divided by the $20 a share price)
Non-DRIP dividend= $121

You can see that after only 3 years, because our dividends are buying us more shares, we are increasing our annual dividend over the no-drip holders. Lets fast forward to the end of the ten years and see where we end up

Year 10
Shares= 191.84
Dividend= $450 or 22.5 more shares
Non-DRIP dividend= $235.79

At the end of ten years, the DRIP plan has a total of 214.48 shares in the account. At the stable price of $20 a share, this brings the DRIP account value to $4,289.60 for a gain of 114% or 11.4% annually. This also means that the drip plan delivered a 48% greater return than the non DRIP plan.

Drips also have the advantage of protecting you if the stock price drops. Should the price of the stock drop, your drip plan is purchasing you MORE shares of the company. This is in a way an insurance policy.

Enrolling in a DRIP usually takes less that a minute. If you use a broker like E*trade, you can do it online without filling out a form. Just click and submit.

DRIP plans are an easy way to increase your returns without doing any extra work on your end. Remember, these results were accomplished without the price of the stock increasing a single penny!! Had it increases at all, the returns would have been magnified.

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