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Dividends 101 - The Beginner's Step-By-Step Overview of How Dividends Work

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Stock Dividends and How They are Different From Stock Splits
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Stock dividends are issued when a firm mails additional shares of stock to the owners instead of, or in addition to, cash dividends. Although you aren't any richer with stock dividends that you were before, there are strong psychological benefits.

Stock Dividends

A stock dividend is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity (i.e., how fast an investor can turn his holdings into cash). Why does lowering the price of the stock increase liquidity? On the whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading hands each day.

 

A practical example of stock dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of 1 million) and sends these to the shareholders based on their current ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of common stock. The 20% dilution in value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

A stock split is, in essence, a very large stock dividend. In cases of stock splits, a company may double, triple or quadruple the number of shares outstanding. The value of each share is merely lowered; economic reality does not change at all. It is, therefore, completely irrational for investors to get excited over stock splits. If you do not still fully understand this, you must read How to Think About Share Price. It will clear up any lingering confusion.

One of the more interesting theories of corporate dividend policy is that managements should opt for stock dividends over all other kinds. This will allow investors that want their earnings retained in the business (and not taxed) to hold on to the additional stock paid out to them. Investors that want current income, on the other hand, can sell the shares they receive from the stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself” dividend.

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