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Dividend reinvestment plans in focus
Dividend reinvestment plans allow shareholders to reinvest their dividends in a company, with shares often offered at a discount to the market price. Separately, share buybacks do the opposite; you sell your shares back to the company. There are many pros and cons to each when deciding whether to participate according to financial experts.
Under a dividend reinvestment plan (DRP) shareholders are offered the choice of receiving a cash payment or using their dividends to buy additional shares in the company. According to Scott Keeley, senior financial adviser with Wakefield Partners, DRPs offer several benefits. Shareholders are usually not charged a commission or additional brokerage costs when buying shares and they are often issued at a discount to the market price.
“The ability to obtain more shares at no cost, and perhaps at a discount, is an excellent way of compounding your returns and steadily growing your portfolio,” Keeley says. “It is essentially another form of regularly investing into the share market, which often provides excellent outcomes for long-term investors.”
The long-term benefits of DRPs are especially noticeable with shares purchased during times of market turmoil and held for the longer term. “This ‘passive investing’ approach ensures those participating in DRPs are regularly investing at all stages of the market cycle,” he says.
HLB Mann Judd Sydney wealth management partner Jonathan Philpot (pictured) says DRPs are a great tool to build wealth and may suit investors who do not need dividend income for living purposes.
“Often DRPs suit those who are building up their wealth,” he says. “Given that dividends form a large part of the overall return from Australian shares, if the dividends are then being re-invested into purchasing more shares, the value of the share portfolio will build much more quickly than those who do not participate in DRPs and spend the dividend income.”
“Also, with good companies, the share prices tend to rise over the long term, so often participating in the DRP of that business has meant good share purchasing along the journey; you build up more wealth in good businesses,” says Philpot.
Downside to consider
The biggest downside of DRPs is investing into a stock that falls in price over time. “If the company’s price falls, say 50 per cent, all those DRPs now look like a poor investment. It is why you should regularly review your portfolio and make sure it is well diversified and not too heavy in one particular stock or sector,” Philpot says.
Another downside is that administration and record keeping is more complicated where DRPs are used; each parcel has its own cost base which can make the CGT calculations more complex if the shares are eventually sold, says Keeley. According to the ATO, if you participate in a DRP you are treated as if you had received a cash dividend and then used the cash to buy additional shares for capital gains tax (CGT) purposes, which can make for painstaking book-keeping as the cost base of shares purchased through DRPs is constantly moving.
Discounts not always on offer
Whether a company offers a discount on the current market price of the company’s shares may depend on its size and how much of its focus is on growth.
“Companies that are perhaps in a more growth-focussed phase and would therefore like to retain capital often offer DRP at a discount as a small incentive for the investor to leave their dividend with the business, taking additional shares instead,” says Keeley.
“More mature, stable businesses (such as banks) which perhaps do not need the capital are less likely to offer a discount.”
Indeed, the big four banks generally do not offer discounts on their DRPs, says Nathan Zaia, Morningstar’s bank analyst. The Commonwealth Bank recently reported its full-year results over the final year ended June 2022 but offered no discount on the DRP. “I wouldn’t expect [the other] banks to introduce a discount on the DRP any time soon. You usually only see a discount offered when the bank (or any company) is trying to encourage a shareholder to participate in the DRP, because they want to retain a little more capital than they otherwise would if the shareholder takes the cash payment,” Zaia says.
Philpot notes that even if a discount is offered, the size of the discount shouldn’t be the decisive consideration in deciding to participate. Instead, investors “should be more based on their own individual needs and their personal share portfolio”.
Selling shares back a separate consideration
Share buybacks are the opposite of a dividend reinvestment plan, whereby shareholders sell some of their securities back to the company and the company’s shares on issue declines. “Buybacks will involve an offer from the company to buy back your shares, often at a price similar to the prevailing market value, but sometimes a little lower,” Keeley says.
Share buybacks can be completed on-market or off-market. With off-market buybacks, a benefit is that the components of the buyback price can involve a fully franked dividend, and/or some franking credits, with the remainder being a capital component, “making them an attractive option for some investors who were worried about large CGT bills down the track,” Keeley says. That compares to an on-market share buyback where the money received by the shareholder is entirely capital
