What Are Stock Dividends?
By: Ned Piplovic,
Stock dividends are distributions of a company’s earnings to shareholders in the form of additional shares of a company’s stock as a substitute for cash payments.
Dividends are distributions of equity assets to a company’s existing shareholders. Stock dividends are an alternative to cash payouts, which are the most common method of dividend distributions.
Types of Dividend Distributions
Stock dividends are one of a number of in-kind variations on standard cash dividends. Additional methods include property dividends, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables and promissory notes.
While cash dividends seem to be the most convenient method from the shareholders perspective, stock dividends have their own advantages for the shareholders receiving the payments, as well as the company or other legal entity distributing the dividends.
While few equities will have a policy of distributing stock dividends, most will make the decision to pay a stock distribution as a response to a specific financial situation or corporate financial strategy. Generally, companies will use stock dividends as a cash distribution substitute when the company has cash flow problems or when its cash on hand is insufficient to cover a normal cash dividend.
Advantages and Disadvantages of Stock Dividends
The main advantages of stock dividends are two-fold. The advantage to the shareholders receiving the dividend is that the Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, the investors do not incur any tax liability for the year in which they received the stock dividend distribution. The tax liability occurs only when the investors sell their shares. However, at that point, the applicable tax rate is the capital gains rate, which is lower than earned income tax rates applicable to all cash dividend distributions, other than those on qualified dividends, which are always taxed at capital gains rates.
Stock dividends also can be advantageous for the equity distributing the dividends. When a company finds itself short of cash, the company might resort to issuing additional shares and distributing those new shares to its shareholders instead of the cash payouts.
Additionally, a company might use a stock dividend distribution to lower its share price. By issuing additional shares of its stock, a company can reduce the share price without any change in the company’s total value. Occasionally, a company’s management might want to reduce the share price to encourage existing shareholders to hold onto their current shares or attract new investors by reducing its price to earnings ratio.
A stock dividend distribution delivers to shareholders a return on their investment and the company does not have to borrow cash or deplete its cash position. The stock type of dividend payouts is also common in restructuring deals and corporate mergers.
Stock dividend distributions dilute the existing shares, which means that the additional shares lower the price per share because the total value of the company is distributed across a larger number of shares. However, shareholders receive the diluted amount in the form of additional shares given as dividends. The net effect is no change in the total value of shares held by individual investors. Even with cash distributions, the share price adjusts down by the dividend per share amount on the day that the stock goes ex-dividend.
While businesses can distribute their dividends at any interval they choose, most companies pay dividends in regular intervals, such as quarterly or monthly. Because they generally report their financials twice per year, European companies also favor a semi-annual dividend distribution schedule.
Like their cash counterparts, stock dividend payouts can follow any distribution frequency. Since companies often use stock dividend distributions in response to their cash flows, this type of dividend payout generally does not follow a set schedule. However, if able to choose, most companies will set a distribution timetable that aligns with their financial reporting schedule.
While the distribution method differs, the metrics used to evaluate cash dividends apply equally to stock dividends. Therefore, regardless of whether they receive the dividend distribution as cash or shares of a company’s stock, investors should consider the dividend yield, the dividend payout ratio, record of consecutive dividend hikes, etc. Furthermore, the important dates in the dividend distribution cycle and their significance in planning a dividend portfolio strategy remains unchanged.
A stock dividend where the amount of additionally issued shares does not exceed 25% of the previously outstanding shares is called a “small stock dividend.” Alternatively, a distribution that adds more than 25% of new shares is a “large stock dividend.” However, a large stock dividend is technically a stock split and should be handled as such.
Many amateur investors might be unfamiliar with stock dividends, or even intimidated by them. This article is aimed at bridging that knowledge gap by providing some basic definitions and explanations that shed light on stock dividend distributions as just another method to share corporate earnings with a company’s shareholders. While very similar to their better-known sibling – cash dividends – stock distributions have few additional nuances that investors must keep in mind when investing and cashing out of their positions.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.