Australian shares offer among the best dividend yields in the world. Investors, both locally and abroad, have been chasing yield aggressively ever since global economies started to scratch and claw their way out of the GFC in 2009. With asset prices smashed, yields were the only game in town as investors hunted the globe for an income.
But what if your investment goals are not just about receiving cash income? What would you do if you were happy to forgo some income now for the opportunity to grow your asset base and earn much bigger cash down the track?
Hi, I’m Matt Hibbard. I’m the income investing specialist for Money Morning.
Before I joined the Money Morning team, I spent the previous 20 years in a number of roles. I traded on the Sydney Futures Exchange, I spent time working as a private trader, and I also worked for a UK derivatives firm in Melbourne.
Like many traders, I’ve often wondered whether, with all the time and energy spent in trading in and out of the market (essentially trying to time the market), it would have been better to pick a handful of stocks, sit back, and watch them compound over time? It is not just ‘set and forget’ as some like to say. You always need to actively monitor your investments. More than that, you must be prepared to change your strategy if it stops working.
But if building an asset base was your long term goal, how might you go about it?
You earn it by participating in what I like to call the ‘secret payroll’. More specifically, this is a company’s Dividend Reinvestment Plan (DRP). I believe signing up for a DRP is one of the best ways investors can build asset bases over the long term. Let me explain how it works….
What is a DRP?
A Dividend Reinvestment Plan or DRP, allows a shareholder to take some, or all, of the dividend amount in the form of additional shares. The investor can nominate what percentage they wish to split between cash and shares. For example, an investor may decide to receive half of their dividend in cash and the other half in shares. Often, these shares are offered at a discount.
Not all companies offer DRPs. However, there are many ways to check which ones do:
- Go to the company’s website. Click on the tab for investor or shareholder information, and go to the section on dividends. It will tell you if they offer a DRP;
- Check with your broker;
- Check online sites and specialist publications.
Typically, it is mainly blue chip companies that offer DRPs, due to the additional resources required in managing them. But spend some time researching it and see what you find.
How Dividend Reinvestment Plans work
AAA Corporation has a DRP, declaring a dividend of 50c per share. Eligible shareholders will receive this dividend at a specified date.
An investor who owns 1000 shares will receive a cash dividend of $500. If the shares are trading at $10, an investor who participates fully in the DRP will receive 50 new shares.
Let’s say the Directors of AAA Corporation have declared that shares purchased under the DRP will receive a discount of 2% to the average closing share price of the last five days. If the average closing price is $10, the company will issue shares at the discounted price of $9.80.
The investor who owns the 1000 shares under the DRP will now receive 51 shares (500/$9.80) for a total value of $499.80. The investors DRP account is credited with the 20c remaining, which is then put towards their next allocation.
An example of a DRP
Westpac’s [ASX:WBC] financial year for 2015 closed on the 30 September. They declared a final dividend rate of 94 cents per share, and distributed it to their shareholders on the 21 December, 2015.
The DRP allocation price was set at $31.83. Westpac calculated this price by taking an average share price of 10 trading days, commencing from 18 November, 2015. The dividend was 100% franked at the corporate tax rate of 30%.
An investor who owned 1000 shares in Westpac would have received a final, fully franked, dividend of $940. Under the DRP, they received 29 additional shares for a value of $923. Remaining funds ($17 in this case) are allocated towards the next DRP allocation.
The power of compounding
Under the Westpac example from above, the investor who participated in the DRP would now own 1,029 shares in Westpac. For some, that may not represent a huge increase off the bat. But here is the kicker with DRPs.
In six months’ time their DRP allocation will be calculated on a base of 1,029 shares. Say that, in the next allocation, they receive 31 shares. They will now have a holding of 1,060 shares. And this is in the space of just 12 months. This continues to grow each time the company distributes its dividend.
Magnify this out by three, five, or 10 years and you start to get an idea of just how much wealth can be built over time. Invest this way for decades and the potential is astonishing. Commonwealth Bank first offered shares to the public in September 1991 at an issue price of $5.40. If an investor had taken their cash dividend and purchased more CBA shares at each distribution, you can imagine what their shareholding would be worth now. At time of writing, CBA is trading at around $75 and yielding around 5.7%.
And this is another advantage of DRPs. It takes away the timing issue that faces all investors. In the introduction, I mentioned the difficulty traders face trying to time themselves in and out of the market. A blue chip stock typically distributes a dividend every six months. Across market cycles, the investor will sometimes receive some allocations at a cheaper price. At other times they will be more expensive. But over time it evens itself out.
Other advantages of DRPs are that, typically, shares allocated do not incur costs such as brokerage or fees. And sometimes, though not always, companies may issue shares at a slight discount to the prevailing market price.
Compare cash versus shares over time
One way to see which performs best is to look back over time and do a comparison. Suncorp [ASX:SUN], for example, is a company that offers a DRP. Go to their website and follow the tabs through to their dividend section.
Note the cash amounts the company has paid out in dividends over time. Now, look at the history of the DRP. Check out the DRP share allocation price over the same period and see how much the shares have appreciated in value. You can start to gauge which strategy achieves the better return over time. You can then repeat this exercise with other listed companies that offer DRPs, to see how they compare as well.
How to participate in a Dividend Reinvestment Plan
When an investor first buys stock in a company they will receive forms from that company’s share registry. These forms will ask the investor for their tax file number, and how they wish to receive shareholder communications for such things as the company’s annual report.
If the company pays a dividend, it will also ask the investor to provide a BSB and account number from their nominated financial institution. The investor then receives their dividend at the designated disbursement date as set by the company.
Companies that have a Dividend Reinvestment Plan will also offer the investor the opportunity to participate by ticking a box on one of these forms. Investors who participate can then decide what portion of their dividend they will allocate to the DRP. But you don’t have to be a new shareholder to participate. Existing shareholders are eligible as well.
Opt in, opt out
It is important to remember that the investor decides when, and if, they join a DRP program. They can opt in or out at their discretion. To change, the investor just needs to fill out a form and mail it back (or do it online if the company’s share registry has this availability). If they do wish to change, they need to notify the company in sufficient time prior to a dividend recording date.
Note that, while companies may offer DRPs, they can also suspend them. Telstra [ASX:TLS] suspended their DRP in 2008, reintroducing it for the 2015 financial year. Companies may also limit the amount of new shares issued under a DRP.
As with any taxation issue, please seek specialist advice. However, as a guide, the ATO includes on their website the following in relation to the Capital Gains Tax (CGT):
- Shares acquired through a DRP are treated as though the investor received a cash dividend and then used this cash to buy additional shares in the company;
- As such, dividends reinvested under the DRP are assessable as income tax — the same as if they were cash dividends. That is, they need to be included in each year’s assessment;
- The price paid by the investor for the shares issued under the DRP form the cost base for the calculations of CGT, should the investor decide to sell those shares in the future.
Other things to consider
A DRP is a good way of building up a shareholding in a good company over a period of time. However, you need to avoid becoming too heavily invested in just the one stock as your shareholding grows.
An investor also needs to decide if they would be willing to purchase the shares issued under the DRP at the allocation price. Could they allocate their money better somewhere else?
Overall, you can view a DRP as being a bit like a voluntary savings plan. The investor forgoes cash in the immediate term to build up an asset over time.
ASX stocks offering Dividend Reinvestment Plans
Finally, let’s look at some high profile ASX companies to see which ones offer a DRP as part of their dividend program:
Income Specialist, Money Morning