Is It Better To Take Dividends Or Reinvest?

Introduction

Investment strategies tend to play a very important role in determining the overall returns that can possibly be generated from a certain investment.

Amongst the wide variety of options that investors have relating to how they can possibly tackle their investments, it can be seen that they have an option to either cash in on their investments in the short term, or hold them for a longer-term for even better returns.

Theoretically speaking, it can be seen that dividend policies, and the fact that drawing dividends depends on the personal preference of the investors, and their expectation thresholds from the investment proposal that is drawn.

As a matter of fact, there is no doubt to the fact that this also varies from person to person, and therefore, this is something that should be considered when it comes to determining the best course of action that can ideally be taken when it comes to deciding on investment strategies.

Dividends Vs Reinvestment

Speaking of dividends, it can be seen that they are probably the most favorable option for those who have an appetite for short term financial gains as an outcome of the stock investment.

This appetite is not to be generalized, and it can be seen that dividend payouts often act as signaling in a positive manner because they reinforce the investor confidence that the company is doing well.

It also reflects on the company’s ability to generate profits, which is promising for the future outlook.

In the same manner, it can also be seen that dividends tend to act as a testament regarding the performance of the company, and how it has managed to generate positive returns as a result of the investment that is drawn.

On the contrary, it can be seen that reinvestment has different objectives and motifs, predominantly on the grounds of long-term impact it is meant to have for the company.

Organizations mostly retain their finances for reinvestment in order to ensure that they are able to expand their operations, or invest into some business deal that is probable to exponentially increase their profitability over the course of time.

Hence, there is no doubt to the fact that this is a clear plus for the company, and it tends to offer promising avenues for the investors in the longer run, because it is likely that profitability is going to exponentially increase over the course of time.

Reinvestment, just like dividend payouts, also have a signaling affect. While in most cases, it is expected that reinvestment strategies are likely to be appreciated by investors.

This is because they are likely to rely on the future prospects of the company, and the value addition that is going to subsequently follow after the reinvestment has been subsequently been executed.

However, on the other hand, reinvestment strategies can also pose to be a threat in certain ways. This is because of the fact that certain investors tend to be doubtful regarding why company has retained dividend payouts, and if everything is fine within the company.

If the strategy is not communicated properly, and in advance, this might result in unwarranted anxiety within the investors, regarding the viability of their outcome.

Dividends or Reinvestment – what is better?

As mentioned earlier, it can be seen that dividend payouts, as well as reinvestment strategies tend to have their ups and downs.

Therefore, it is rudimentary to realize that both these options can equally be considered as promising for investors.

From an investors’ perspective, there are a couple of theories that can be used to explain their preference. These theories are explained below.

Firstly, there is Bird in Hand Theory. This dividend theory speaks that the dividend payout tends to be more motivating from investors perspective because of the reasons vested in finance theories, relating to Time Value of Money, and other relevant finance concepts.

It speaks of how money in hand is worth more than money that is to be received in the foreseeable future. This is a relatively risk adverse approach, and keep the investors interest intact in their relevant investment.

On the other hand, there are other growth-related prospects that need to be considered when it comes to dividend and reinvestment strategies.

A way to look at this is the fact that if the company retains their earnings for purposes of reinvestment, it is likely that they would have promising prospects in the future.

As a result of this, it can be seen that as a result of growth in investment in the company, the investment is likely to exponentially increase in the market.

The growth prospects can also tend to be appealing for the investors because it increases their investment considerably, and this can lead to higher returns in the future, in comparison with immediate dividend payouts.

Conclusion

Therefore, it can be seen that dividends and reinvestment can be considered to have their positives and negatives in terms of extrapolating positive returns.

As a matter of fact, it can be seen that dividend payouts tend to be plausible for the shorter term. This is perhaps a good option is the company is mature enough, and expansionary opportunities are somewhat limited.

This would be appealing because of the reason that short term dividends would keep the investors happy and content in terms of their investment.

On the contrary, reinvestment can be referred to be ideal for investors who are not in investments for longer term.

This is because reinvestment strategies are often referred to as long strategies, which tend to benefit shareholders over the longer course of time.

However, what needs to be highlighted here is the fact that reinvestment might not always render the desired results, and therefore, this is something that should be considered by these investors.

The risk return phenomenon in this regard is also helpful to gauge and determine the return that is likely to be generated as a result of this investment, and if investors are aligned in this regard.

WHAT IS THE DIFFERENCE BETWEEN SCRIP AND DRIP DIVIDENDS?

The ownership of a company is sold through its shares. The company issues its shares that can be bought by different investors. Once investors buy these shares, they become the owners of the company, also known as its shareholders.

The shareholders of the company are given different compensations for their investment in the company. These compensations can be in many forms, such as dividends, voting rights, etc.

Dividends are the compensation paid to the shareholders of a company from the earnings of the company.

These dividends are given in many forms, but most commonly, these dividends are paid in cash.

The dividends of a company are paid from its earnings after a specific period, for example, quarterly, bi-annually, or annually.

These are generally first approved in the annual general meeting of the company before they are paid to the shareholders.

Companies may also pay dividends in many other forms. These include stock dividends, property dividends, special dividends, etc.

Two other types of dividends paid out by companies in which stocks of the company are given to the shareholders are scrip dividends and DRIP dividends, also known as the Dividend Reinvestment Program.

Scrip Dividends

Scrip dividends of a company are paid in the form of a certificate to the shareholders.

The certificate is an offer to the shareholders of the company, which gives them the option to either receive their dividends in the form of cash, in the future or in the form of stocks of the company.

The shareholders do not have to pay for the stocks if they select the latter option.

This type of dividend is used by companies to avoid paying cash to their shareholders. This can be used in circumstances when the company does not have enough cash to pay to its shareholders or may need its cash reserves for some other activity in the future.

Companies can also decide the number of shares that are to be given to the shareholders.

For shareholders, this type of dividend can also be beneficial as they are compensated even when the company cannot afford to pay dividends to the shareholders.

Furthermore, the shareholders can also simply sell the shares received as dividends for capital gain.

Similarly, it allows shareholders to receive additional shares of the company without paying any transaction fees related to acquiring new shares, such as broker’s commissions, stamp duty, etc.

DRIP Dividends

DRIP stands for Dividend Reinvestment Plan. This is a program that is offered to the shareholders to allow them to reinvest their cash dividends in the shares of the company.

The offer to reinvest in the shares of the company comes in the form of investing in the existing shares of the company.

Sometimes, it may also offer a discount towards any future purchase of the company’s shares by the shareholders.

DRIP dividends are mostly used by companies to encourage shareholders to invest in the company. DRIP program can also generate extra funds for the company, unlike scrip dividends, where shares are given out without any compensation received.

The company operating the DRIP program may also give shareholders access to the program even outside of just reinvesting their dividends.

For shareholders, like scrip dividends, the shareholders get the option to select whether they want to reinvest their dividends in the program or not.

The shareholders also have the option to reinvest a portion of their dividends and take some dividends in cash form. However, unlike scrip dividends, shares form the DRIP program may have some transaction costs for the shareholders. 

Differences

The main difference between scrip and DRIP dividends is that when a company offers scrip dividends, new shares of the company are issued to the shareholders of the company. Shareholders avoid transaction fees when paid scrip dividends.

However, in the DRIP program, existing shares of the company are purchased from the market which might be subject to certain transaction fees. 

This also means that a scrip dividend issue will dilute the share price of a company due to new shares being introduced by the company.

However, the DRIP program will not dilute the share price of the company as existing shares are given to the shareholders.

Conclusion

There are many options available to a company when deciding on how to pay its dividends. Two of the options are scrip dividends and DRIP dividends.

Scrip dividends give the shareholders the option to be compensated in new shares of the company rather than cash dividends.

DRIP program offers the shareholders the option to reinvest their dividends in existing shares of the company.

Since new shares are issued is a scrip issue, these may cause a share price dilution for the company. This is not the case with the DRIP program, where existing shares are used instead.

WHAT IS A SCRIP DIVIDEND ALTERNATIVE?

The shareholders of a company invest in the company due to several reasons. Some shareholders invest in a company for long-term goals.

These long-term goals are mainly realized in the form of capital gains that the shareholders will receive when they ultimately sell their shares.

However, shareholders with long-term goals may also be interested in the dividends of the company rather than just the capital gains.

Some shareholders, on the other hand, invest in the company for short-term goals. These short-term goals are mainly realized in the form of dividends that the shareholders receive on the earnings of the company.

While these shareholders can also benefit from capital gains in the short-term, these capital gains occur less often. They are lesser than the capital gains that shareholders with long-term goals will generally expect.

A company does not have control over the price of its shares in the stock market as the price is determined by external factors.

This means the company cannot dictate how much capital gain its shareholders will receive. However, the earnings of the company and the dividends that are paid by a company can be controlled by the company.

Mainly dividends are paid from the earnings of the company to its shareholders, in the form of cash dividends. However, in some circumstances, dividends may also be paid as scrip dividends alternatives.

Scrip Dividend Alternative

Script dividends are the dividends that a company pays to its shareholders in the form of a certificate.

The certificate allows the shareholders of a company the option to either receive their dividends in the form of cash or the form of new stock of the company.

The shareholders of the company can decide which option to avail. The shares offered in scrip dividends are based on the existing shares held by the shareholders and a reference price for the shares.

Scrip dividend issues are proposed by the management of the company and approved by the shareholders of the company in the company’s annual general meeting.

This means the shareholders also have control over the terms of scrip dividend alternatives. During the meeting, a reference price is also determined for the scrip issue.

This reference price is then used to determine how many shares will be given to the shareholders of the company instead of the cash dividends.

For example, a shareholder owns 1000 shares of a company, and the dividend per share declared by the company is $6.

The company also determined the reference price of the share to be $75. The company offers its shareholders a scrip issue alternative for their cash dividends.

If the shareholder chooses to opt for the scrip dividends shares alternative, then the shareholder will receive 80 (1000 shares x $6 dividend per share / $75 reference price) shares of the company.

Advantages

Scrip dividends can be beneficial for both the company and the shareholders. For companies, it allows them to pay dividends in an alternate form to cash dividends.

This allows them to keep their cash reserves up to a certain level while also meeting the demands of its shareholders for dividends.

This cash is then used in other projects of the company. For example, a company may offer a scrip dividend alternative to the shareholders of the company if they have an upcoming project in the next period and don’t want to deplete their cash reserves by paying dividends to its shareholders.

For shareholders, scrip dividend alternatives allow them to increase the number of shares they hold in the company free of charge.

By receiving these shares as scrip dividends, they don’t have to pay any transaction fees, such as stamp duty and commissions paid to brokers, as the company deals directly with the shareholders.

Scrip dividends can also have some tax benefits for shareholders.

Disadvantages

Scrip dividends can also have some disadvantages. For companies, scrip dividends result in a dilution of the market value of the shares of the company.

This can make the shares of the company unattractive for any potential investors. Furthermore, while the company maintains its cash reserves by not giving dividends to the shareholders in cash, the company also forgoes any cash that it could generate as capital if it had simply issued the shares to the public.

This means that if the company issues the shares to the general public instead of giving scrip dividends, they can generate capital from it.

For shareholders, while scrip dividends provide an alternative form of a dividend, it cannot completely replace cash dividends.

While the shareholders have the option to not choose scrip dividends, they can potentially lose a fraction that they own if other shareholders opt to receive shares instead.

Similarly, due to the dilution of share prices caused by scrip dividends, the shareholders may also receive lesser dividends than they would if they opted for cash dividends.

Conclusion

Companies compensate their shareholders for their investment and risks in the company by paying them dividends.

These dividends are mainly paid in cash. However, sometimes, these companies may also offer a scrip dividend alternative. Scrip dividend alternatives are offered in the form of a certificate.

This certificate gives the shareholders the option to receive their dividends in either cash form or the form of additional shares issued by the company.

Scrip dividend alternatives can have several advantages and disadvantages for both the company and its shareholders.

HOW DOES SCRIP DIVIDEND WORK?

The companies issue their shares to the general public who can buy these shares to become the shareholder of the company.

These shareholders are considered owners of the company for the fraction of shares they hold compare to the total shares issued by the company.

For their investment, the shareholders get returns in many forms. The companies’ shareholders may get the returns in many form such as dividends or capital gains.

Dividends are a share of the total earnings of a company for a period given to the shareholders. These dividends are declared and then distributed among the shareholders of the company based on their percentage of shareholding in the company.

These dividends may paid in the form of cash. However, sometimes, the company may also give its shareholders an alternative form of dividend known as scrip dividends.

Scrip Dividend:

A scrip dividend is given by the company, in the form of a certificate, to its shareholders. This certificate gives the shareholders an option to avail of a dividend in a future point in time or receive additional shares in the form of dividends.

This means that the company pays its shareholders in the form of additional shares instead of cash dividends. However, the choice to avail the option ultimately lies with the shareholders.

Scrip dividends are used by the company to save cash. Scrip dividends may be given during circumstances when the company doesn’t have enough cash resources to pay cash dividends to its shareholders.

However, companies may also use scrip dividends when they need to maintain their cash reserves in case of a future need.

This cash can be used in future projects or used to maintain a good balance sheet position for the company. In some cases, scrip dividends can also save taxes for the company.

However, the company offering scrip dividends must be cautious of any negative signals the scrip dividends may spread about the company.

For example, if a company relies only on scrip dividends in every period, the shareholders or potential investors may think that the company cannot manage its cash resources properly.

Therefore, to avoid these negative effects, the company must only use scrip dividends in special circumstances.

With scrip dividends, even though the shareholders aren’t paid in cash, they are still paid in shares. Shareholders can sell these shares to make a capital gain on the shares they never paid for.

However, since the shareholders have the choice of whether to avail scrip dividends or not, they may choose not to avail the option and receive cash dividends instead.

Scrip dividends also allow shareholders to increase their shareholding in the company without having to pay additional costs to acquire these shares such as stamp duty, broker’s commission, etc.

Process of Scrip Dividend

The process of giving shareholders a scrip dividend is straightforward. The process begins with the company’s board of directors’ decision to pay scrip dividends. This decision may be due to several reasons discussed above.

A proposal is prepared and presented by the board of director to the shareholders in the annual general meeting of the company. The shareholders, in the annual general meeting, may choose to approve or reject the proposal.

They may also propose changes to the proposal of the board of directors. Once approved, the record date for scrip dividends is finalized in the annual general meeting.

On the record date, the scrip dividends are presented to the shareholders of the company. These are shareholders that own shares of the company at the record date.

At this point, the company will finalize a reference price for the shares. Once a reference price is established, the shares will be issued to the shareholders of the company that have accepted the option to receive the scrip dividend shares.

Scrip dividends are issued to the shareholders based on their existing holding of shares of the company.

For example, the company may issue 1 scrip dividend share for every 5 shares held by the shareholders of the company.

So, if a shareholder owns 1,000 shares of the company, they will receive a total of 200 (1,000 x 1 / 5) shares of the company as scrip dividends.

Conclusion

Scrip dividends are options given to the shareholders of a company to receive their dividends in the form of additional shares instead of cash dividends.

The shareholders of the company can either accept or reject the option. Scrip dividends are given to the shareholders when the company is short on cash or does not want to pay cash dividends.

However, the company must be aware of any negative signals associated with paying scrip dividends. For shareholders, scrip dividends allow them to increase their shareholding in the company without paying additional transaction costs.

DO SCRIP DIVIDENDS GO ON TAX RETURN?

Scrip dividends are certificates paid to the shareholders of a company. These certificates are given to the shareholders instead of cash dividends.

The certificate allows the shareholders of the company to receive their dividends as either cash dividends or stock dividends.

This means when a scrip dividend is paid, the shareholders of the company decide whether they want to receive their dividends as cash or as shares of the company.

Scrip dividends can be beneficial for both the company and its shareholders. Companies generally use scrip dividend alternatives when their cash resources are low or they want to maintain a certain level of cash reserves.

This allows companies to invest the cash into other projects or processes while also providing shareholders with dividends.

For example, if the company expects to invest in a fixed asset in the next period, it may issue scrip dividends as a way to reserve cash to invest in the fixed asset.

For shareholders, scrip dividends allow them to increase their shareholding in the company. Through scrip dividends, they can acquire new shares of the company without having to pay further processing costs involved with acquiring new shares.

These processing costs may include commissions paid to brokers, stamp duties, etc. Shareholders can also sell their shares in the market, after receiving them, for capital gains.

Scrip dividends can also have some disadvantages for the company and the shareholders. For companies, scrip dividends can send a negative signal about the company in the stock market.

If a company uses scrip dividends often, potential investors may think that the company has cash flow problems and cannot pay dividends. This makes investing in these companies unattractive for potential investors.

Furthermore, scrip dividends can cause the market share prices of a company to be diluted. This will cause a decrease in the share prices of a company in the market that can also act as a negative signal.

For shareholders, scrip dividends can also potentially cause them to lose their percentage of ownership of a company.

If a shareholder opts to receive cash dividends but other shareholders of the company opt for the share dividend, then the shareholder will have the same number of shares as before while the number of shares of other shareholders will increase.

In most companies, cash dividends are more common than scrip dividends. Therefore, some shareholders may be confused about the tax treatment and implications of scrip dividends.

The process of taxation of scrip dividends starts from the financial institution, such as banks or brokerage firms, through which the shareholder receives their dividends.

Scrip Dividends On Tax Return

Script dividends are reported using the Form 1099-DIV. For shareholders, when they are preparing their tax returns, scrip dividends should be reported as income for the period.

However, if the shareholders choose to hold their shares in a retirement account, these are not taxed in the year they are earned.

The ‘Form 1099-DIV: Dividends and Distributions’ is sent to taxpaying individuals by financial institutions.

The financial institutions send the form to individuals with any dividend or distribution incomes from their investments within a calendar year that are above $10.

If an individual receives different dividend incomes through different institutions, they may also be sent multiple copies of Form 1099-DIV. The forms are reported in the taxpaying individual’s tax returns.

The financial institutions typically send these forms to the taxpayers before 31st January every year. Taxpayers are then required by the IRS to file the information on each Form 1099-DIV they receive on their tax returns.

The information is reported on a Schedule B form of the taxpayer or directly on their Form 1040. This is the normal process for ordinary dividends received by individuals but also applies to scrip dividends.

DRIP dividends can also be reported using the same process.

Scrip dividends are treated in the same manner as ordinary dividends paid in cash for tax purposes.

The dividend income that is received by individuals, whether in the form of cash or stock, is taxed at the same rate as other incomes of the individuals based on how much their total income is.

Conclusion

Scrip dividends are paid by a company when the company is short on cash resources. It is an alternative to cash dividends.

Scrip dividends have many advantages and disadvantages for both companies and their shareholders. Shareholders receive Form 1099-DIV for dividends from the financial institution through which they receive their dividends.

Shareholders can also receive multiple copies of these forms from different financial institutions. The information on the form is reported on the tax returns of the shareholder.

Limitation of Dividend Valuation Models

There are some drawbacks of the Dividend Valuation Models which include factors like the difficulty of perfect projections and the assumptions of income from dividend.

Although the principle behind the model is simple but applying the theory is challenging. The limitations of Dividend valuation Models are described below:

  • The reality is that in some companies dividends grow over time and in some companies dividends will not grow at a specific rate until a certain period of time. Other companies may reduce their dividends or don’t pay at all. This means the model can be best applied only to those companies who have constant dividend payment policy.
  • The model can be used on those stocks that pay dividend. In most small organizations or start-ups, the model cannot be applied to determine their value as they are not in a position to pay dividend. Investors may miss a number of opportunities if they only focus on Dividend Valuation Model.
  • The model doesn’t consider non-dividend factors. There are many non-dividend factors like customer retention, intangible asset ownership, brand loyalty which can change the valuation of the company. Using a stable dividend growth rate when the model calculates the value it may not give expected result.
  • The model ignores the effects of stock buyback. Stock buybacks can have a significant impact on stock value when shareholders receive the return. This means the model is conservative in nature and using the model investors ignore other factors which can affect the final value of stock.
  • The model only values dividends as a return on investment. There are many ways of increasing portfolio by investing in stocks, bonds, mutual funds and other financial products. The model only looks at dividend stocks that means investor’s portfolio may not have the diversity that is required during a period of economic recession.
  • The model is very sensitive to the quality of information involved. The model’s success or failure depends on the inputs provided to it. When information is accurate, the valuation may be accurate. When assumptions used by investors are mostly accurate, they will find the model to be working properly.
  • When there are large variations in earnings and the maintenance of a stable dividend payout occurs, companies borrow money to ensure their status as a regular dividend provider. As the model assumes dividends are tied to earnings, in this case the model becomes worthless.
  • The model is prone to personal bias because investors use their personal assumptions and experience to value the stock. If an investor as a good viewpoint for a stock the valuation result will come good although the real picture is different. In this case, involving a third party to look over the information can be helpful.
  • There is a fact that the model is full of too many assumptions. The assumptions are the required rate of return, growth rate and tax rate. Most of the assumptions are not within the control of investors. So, this issue reduces the validity of the valuation model.
  • The model is not worthwhile in another sense that it does not take into taxation rules. In most of the countries tax structure is created in such a way that paying dividends is not advantageous from taxation perspective. For this reason, many companies choose to invest their profits back to their business. So, considering taxation rules the model fails to guide investors.
  • The Dividend Valuation model have limited use because it can only be used to mature and stable companies who pay dividends constantly. Investors generally invest in mature and stable companies and don’t focus on growing companies. Growing companies face lots of opportunities and want to develop in the future. For this purpose, they need more cash on hand and cannot afford paying dividends. Investors miss this companies because of the fact of not paying dividend.

The model is not applicable to large shareholders because they have a big shareholding and some degree of control and can influence the dividend policy. So, the model is not very useful for investors who are interested in investing in high risk-return companies.