Weighing up the pros and cons of dividend reinvestment

While they might seem alluring, dividend reinvestment programs (DRP) may result in you throwing good money after bad.

During the share market's upward-trending, golden years, many shareholders were understandably thrilled to participate in the DRPs offered by Australia's biggest listed companies.

At face value, DRPs were regarded as a cost-effective way of automatically reinvesting dividends, while the power of compounding returns contributed directly to their long-term wealth.

But due to significantly lower brokerage fees, a lower cost of debt and heightened share market volatility, the bigger question today is whether good capital management – which motivates companies to turn DRPs on or off – and the best interests of shareholders, remain mutually exclusive propositions.

How DRP’s work?

It’s not brain surgery, rather than take a cash payment, about 200 of the 400-plus ASX-listed stocks that issue dividends typically offer shareholders the opportunity to purchase additional shares with their dividend payment.

As an extra sweetener, these additional shares are often purchased through a DRP at a discount of up to 5 percent to market. Everything being equal, a company's decision to turn DRPs on or off typically depends on whether it can deploy the cash better elsewhere within the business.

They come and go

Remember, covid aside, while banks and financial stocks are more likely to have DRPs running permanently - it’s not uncommon for resource stocks to turn their DRPs on or off to best match the needs of the business.

Then there are mining companies that issue a "Claytons" dividend they'd rather not pay and use DRPs as a form of de-facto capital raising.

It’s equally important to remember that when a company continues to pay underwritten dividends, your holding in the company can quickly get diluted, if you choose to not participate in the DRP.

Disadvantages

One of the biggest disadvantages in participating in DRPs is shareholders have no say at what price they receive new stock. Even if the DRP is discounted, you are still buying shares at a price you have no control over.

So, if a stock is trading higher than its intrinsic value, as an investor you need to distinguish between value and lazily buying more of the same stock.

One option is to opt in or out of DRPs at dividend time based on the degree to which the stock is under-priced.

If you don’t like the prospect of overpaying for more stock, why not take the cash and decide what you buy, when and at what price?

Messy record keeping

Another reason DRPs can be more troublesome is that each dividend reinvestment is effectively a separate share purchase. That means the cost base for capital gains tax (CGT) is determined by the market price of the shares at the time of each associated dividend distribution.

With this complicating the record-keeping required by the ATO on losses and gains on each parcel, it’s understandably why some shareholders are only too keen to take their dividends as cash.

Admittedly, DRPs are an enforced savings strategy, but if you wouldn't buy that stock again today, holding more of it may not be a great idea.