A way for a company to save money but still pay a dividend is called a scrip dividend. This takes the form of a listed company creating more shares in the firm and giving them for free to existing shareholders. This is called a scrip issue.
It is a form of secondary issue and could also be well described as a way for a company to capitalise financial reserves.
Generally, a firm will pay one new share for a certain and fixed number of existing shares already owned. For example, this may take the form of one new share for every 20 held. This would be called a 1 for 20 scrip dividend.
Therefore, if an investor owned 500 shares in a firm, and a 1 for 20 issue is paid, the investor would be entitled to 25 new shares. These are in addition to the current holding.
This is essentially a bookkeeping exercise and so the ROCE (Return On Capital Employed) should not change. A scrip issue does not change the value of a company and so an investors holding will be the same value before and after. The ex-scrip price is calculated as:
Ordinary shares held x Original share price
Total number of new shares held
It is worth noting that should an investor sell the newly issued shares, the proportionate holding in the company is reduced.
Therefore, if we follow our example still further and the current price per share is 10.50.
500 x 10.50 divided by 525 = 10.00 (Ex-scrip price)
The investor could sell the new scrip shares and receive:
10.00 x 25 = 250.00
This is a rather ingenious way of offering a reward to shareholders without the need to actually release money. For some investors, it will offer a tax efficient way of receiving benefits from a holding.
Often, an investor may choose to sell the scrip issue, making a capital gain rather than receiving an income. If the investor has not exceeded his or her annual capital gains allowance, the sale will be tax free. Obviously, it goes without saying, that this depends upon the situation of the individual.
However, since in the UK the majority of investors do not pay capital gains taxes, this is a more tax efficient route of releasing funds to investors.
If you click here you can read my only ever submission to Wikipedia, where a scrip issue is explained.
What Are Dividend Reinvestment Schemes?
Depending on which study you read, dividend reinvestment is either very important to the long term returns to an investor or very, very important.
However, it is very difficult for a small scale, individual investor to do. If you
only hold a few hundred or a few thousand shares in a company, the annual dividend payment can often be lower than the total dealing cost to reallocate the new money. Or if it is above that cost, it might still eat up the majority of the payment, making any reinvestment financially unappealing.
Recognising this, many larger companies with tens or hundreds of thousands of shareholders now operate something often called a DRiP. This is a Dividend Reinvestment Plan. Rather than be sent your annual cheque, the firm will purchase as many additional shares as the money will buy at very low dealing costs.
By arranging such a scheme for thousands of investors at a time with a stockbroker, they can use economies of scale to keep the dealing fees as low as possible. This is important since the 'drag' of fees is one of the main impediments to a successful portfolio.
The money will almost certainly have any relevant taxes automatically deducted before it is applied (usually some form of dividend withholding tax which depends upon where the investment is located and where you are personally resident, and any stamp duty required by law as a part of the purchase), but it allows the little guy to reap some of the same advantages that were previously only open to funds and major corporations.
The main attraction of dividend reinvestment is the potential for a compound return on interest. This is very powerful and every investor should want to harness the power of compounding. Earning a growing amount of 'interest' (your return) on a growing amount of interest is a beautiful thing!
By reinvesting dividends, more shares are bought each year. These new shares will also produce an income stream which can be used to purchase more shares in future years. Over time, this has the power to make a significant improvement to the value of a holding. And, as we read from the likes of Warren Buffett, time is a very important factor in long-term investment.
To quote Charles D. Ellis from his excellent book Winning The Loser's Game. too many investors buy and sell far to often and instead should follow his maxim, "Don't just do something, stand there! " to really let the power of compounding work for their holdings.
If the holding is also increasing in value at the same time, this will provide an impressive improvement in performance. A combination of an increasing number of shares plus an increasing stock price and - hopefully - an increasing annual dividend payment will do wonders for your portfolio. We hope that you one day see such a combination!
Please follow this link to see how one major UK stockbroker handles this for their private investor clients.