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Investor Education Heinzl on dividends: How to DRIP an ETF, and making sense of payout ratios

Many personal finance writers recommend dividend reinvestment plans (DRIPs). But a common theme among financial advice givers is to not buy individual stocks but rather invest in exchange-traded funds (ETFs) to spread the risk. Is there such a thing as ETF DRIPs?

Yes. In addition to offering DRIPs for common shares, most discount brokers let you reinvest dividends from ETFs without incurring commission charges.

Broker-operated DRIPs are easy to set up online or with a quick phone call to your broker. Choosing the DRIP option may require you to enroll all of the securities in your account, although some brokers let you pick and choose only the stocks and ETFs you wish to DRIP.

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Check the broker’s website for a list of DRIP-eligible securities, or contact the broker directly if you can’t find the information online.

Before you take the plunge, however, you should be aware that broker DRIPs generally purchase only whole shares. For example, if you receive a distribution of $25 from an ETF with a unit price of $17, you will purchase one additional unit and receive the remaining $8 in cash. Because many ETFs make monthly distributions, the dividend may in some cases be too small to purchase even a single unit.

To make an ETF DRIP worthwhile, you should aim to initially purchase a sufficient number of units so that most of the distribution is reinvested and not all received in cash. I also recommend that you have a plan for “soaking up” any excess cash. Most discount brokers offer high-interest savings account products that you buy and sell like mutual funds; these are a great place to park idle cash that would otherwise earn nothing.

Another option for reinvesting ETF distributions is to choose a broker that offers commission-free ETF trades. There are several brokers to choose from, each with advantages and disadvantages. Scotia iTrade, for example, lets you buy and sell ETFs with no commissions, but the list of eligible securities is small at about 50 ETFs. Questrade lets you buy ETFs for free, but you’ll pay the standard commission when you sell. Wealthsimple Trade lets you buy and sell stocks and ETFs for free, but for now it’s only available for non-registered accounts and tax-free savings accounts. A few other brokers also offer commission-free ETF transactions.

If your goal is to reinvest all of your cash, having the option to purchase ETFs with no commissions is a big advantage. Simply wait until enough cash builds up to purchase at least one ETF unit, and then enter a buy order. It’s more work than a DRIP, but it will make sure all of your money is working for you.

Whatever method you choose, investing in ETFs will provide diversification, and reinvesting your dividends will harness the power of compounding – one of the most important components of a successful long-term investing plan.

Can you please explain how some companies can sustain dividend payout ratios of close to 100 per cent, or more in some cases? One example is Six Flags Entertainment Corp. (SIX).

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Payout ratios can be measured in different ways. Usually, the payout ratio provided on financial websites is the percentage of earnings paid out as dividends. Paying out close to 100 per cent of earnings can be a red flag in many cases, but for certain companies it’s more useful to measure the payout ratio based on actual cash flow generated by the business. That’s because earnings are reduced by accounting charges such as depreciation and amortization that don’t affect the company’s cash flow or its ability to pay dividends.

In the case of Six Flags, the amusement park operator reported net income of US$276-million or US$3.23 a share in 2018 and paid dividends of US$3.16, for a payout ratio of 98 per cent based on earnings. But the company also uses a measure called adjusted free cash flow, which it says helps investors “evaluate the company’s underlying performance.” In 2018, Six Flags generated adjusted free cash flow of US$292.9-million or about US$3.43 a share. This was after paying all of its expenses and investing $133-million in its theme parks business. Based on adjusted free cash flow, the payout ratio was about 92 per cent – still on the high side, but consistent with the company’s policy to return all excess cash to shareholders in the form of dividends and share buybacks. It’s worth noting that Six Flags has raised its dividend for eight consecutive years. I’m not suggesting that Six Flags is a good (or bad) investment, just that its payout ratio may not be as egregious as it seems.

Because there is no standard definition of payout ratio, if you’re interested in a stock it’s imperative that you read the company’s investing materials carefully so that you understand how the ratio is calculated. And remember that the payout ratio is just one factor to consider when making an investment decision.

E-mail your questions to jheinzl@globeandmail.com.

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