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Stock Dividends Definition / Meaning
An investor invests in the stocks of a company only and only to generate more wealth. This expectation is met primarily in two forms: Capital Appreciation and Dividends. The amount of capital appreciation varies over the length of investment. But a rational investor expects the company to pay out dividends on a regular basis. The dividend is the minimum and the most fundamental return an investor anticipates from a company for having parked his very valuable funds with it. Traditionally the companies share their profits with the stakeholders through payment of the dividend in cash. However, there exist some exceptional situations where the companies resort to non-cash means of profit-sharing. One such is stock dividends.
Stock dividends are payments made to the shareholders as incremental stocks on their existing holding. Stock dividends are a step away from cash dividends. Instead of actual outflow of cash, the stockholders further receive stocks with no change in the total value of their original holding. In essence, stock dividends are nothing but capitalization or reallocation of profits. Companies usually resort to it when the cash flows are tight but want to pass on the profitability to its shareholders.
Stock Dividend Example
Stock dividends are usually issued as a percentage of the existing holding. For example, if a company issues a 25% stock dividend, it implies that the holding of every stockholder would increase by 25%. Thus a stockholder originally holding 100 stocks will hold 125 stocks post the declaration of stock dividend.
Another beneficial aspect of stock dividends is that they are tax-free. Declaration of the same does not give rise to any tax consequences in the hands of the investor or the company. The impact of taxes only comes into the picture when the investor decides to sell his holding or a part thereof in future.
Stock Dividend Benefits
Why Companies Opt to Declare Stock Dividends
Cash crunches remain the most rampant reason why a company may opt to declare a stock dividend. However, it may also be for the following reasons:
Maintaining a Price Range
Declaration of stock dividends has an immediate impact of cutting the stock price (while the total capital remains unchanged) in proportion to which the dividends are announced. Therefore if a company has very high stock price it may be unaffordable to the public at large. This may result in a risk of illiquidity in the markets. Such a situation jeopardizes the company’s reputation and appeal to potential investors.
Moreover, stocks which are not overvalued enjoy an accurate PE valuation and are more likely to generate a favorable trading volume on the exchange.
Accumulation of Non-Cash Profits
Sometimes a company may build up a considerable amount of non-cash wealth, particularly when it has gone through a restructuring of its capital. In such a scenario, though the retained earnings display a healthy balance, in effect the company may not be sitting on a lot of cash. Therefore the company may choose to pass on the benefit by declaring stock dividends. This is done by means of reallocating such excess of retained earnings to the issued capital.
Better Investment Opportunities
The company may be confronted with promising investment opportunities and may be confident of generating higher returns. In such a case there lies more value to the cash at hand when invested in such ventures rather than simply being paid out as dividends. In the meanwhile, to retain the trust of the shareholders and investors the company may declare stock dividends. The high yielding avenues in which the cash is invested would eventually strengthen the market price of the stock. This in return, finally rewards the stockholders in the form of capital appreciation.
The declaration of stock dividends has effectively no impact on the shareholder’s wealth. While the total number of stocks held increase on paper, its total value remains unchanged. This is because the cost of acquisition of the additional stocks received as the dividend is nil.
For example, Mr. Roy holds 500 stocks of a company acquired at $25 per stock. Therefore, the total value of holding at the time of acquisition is (500*25) $12500. Now the company declares a stock dividend of 2 for every 5 stocks held. Thus the stock dividend received by Mr. Roy is (500/5 * 2) 200 stocks, the cost of which is zero. The total holding of Mr. Roy now stands at 700 stocks acquired at $12500.
Impact on EPS
Stock dividends do have a significant bearing on the EPS of the company. They result in a direct increase in the total number of shares of the organization. Thus the effective earning per share reduces when the same amount of earnings or profits are divided among a larger number of stocks.
For example, the total earnings available for distribution with XYZ Inc is $500,000 and the total outstanding paid-up capital is 10000 stocks. XYZ Inc decides to issue a stock dividend in view of shortages of cash at 25%. Thus the total outstanding stocks now stand at 12500.
|Pre Stock Dividend||Post Stock Dividend|
|Total Outstanding shares||10000||12500|
Disadvantages of Stock Dividends
There are some downsides of stock dividends as well. While the stock dividend strategy offers advantages, it may also be disadvantageous in the following ways:
- The market may perceive declaration of stock dividends as an acute shortage of cash or distress in the company. Such a pessimistic assumption may give rise to a selling spree of the stock and the price may start spiraling down.
- As investors, who are not a privy to the internal management of the company it may be difficult to judge the true intentions of the top management. They remain at the mercy of the company and shall never know whether the decision of the company was genuine or was just a way to hoard cash.
- A company may actually be better off paying cash dividend rather than diverting the precious funds to a risky project, the returns of which are uncertain.
References: CFA Curriculum; CA & CMA Final SyllabusLast updated on : May 25th, 2018