A dividend is a distribution of a portion of a company's earnings, decided by the board of directors. The purpose of dividends is to return wealth back to the shareholders of a company. There are two main types of dividends: cash and stock.
Key Takeaways
- Dividends are earnings a company gives back to its shareholders, as determined by the board of directors.
- Dividends can be paid out in cash, by check or electronic transfer, or in stock, with the company distributing more shares to the investor.
- Cash dividends provide investors income, but come with tax consequences; they also cause the company's share price to drop.
- Stock dividends are not usually taxed, increase the shareholder's stake in the company and give them the choice to keep or sell the shares; stock payouts are also optimal for companies that lack sufficient liquid cash.
What Is a Cash Dividend?
A cash dividend is a payment made by a company out of its earnings to investors in the form of cash (check or electronic transfer). This transfers economic value from the company to the shareholders instead of the company using the money for operations. However, this does cause the company's share price to drop by roughly the same amount as the dividend.
For example, if a company issues a cash dividend equal to 5% of the stock price, shareholders will see a resulting loss of 5% in the price of their shares. This is a result of the economic value transfer.
Another consequence of cash dividends is that receivers of cash dividends must pay tax on the value of the distribution, lowering its final value. Cash dividends are beneficial, however, in that they provide shareholders with regular income on their investment along with exposure to capital appreciation.
What Is a Stock Dividend?
A stock dividend, on the other hand, is an increase in the number of shares of a company with the new shares being given to shareholders. Companies may decide to distribute this type of dividend toshareholdersof record if the company's availability of liquid cash is in short supply.
For example, if a company were to issue a 5% stock dividend, it would increase the number of shares by 5% (one share for every 20 owned). If there are one million shares in a company, this would translate into an additional 50,000 shares. If you owned 100 shares in the company, you'd receive five additional shares.
This, however, like the cash dividend, does not increase the value of the company. If the company was priced at $10 per share, the value of the company would be $10 million. After the stock dividend, the value will remain the same, but the share price will decrease to $9.52 to adjust for the dividend payout.
One keybenefit of a stock dividend is choice. The shareholder can either keep the shares and hope that the company will be able to use the money not paid out in a cash dividend to earn a better rate of return, or the shareholder could also sell some of the new shares to create their own cash dividend.
The biggest benefit of a stock dividend is that shareholders do not generally have to pay taxes on the value. Taxes do need to be paid, however, if a stock dividend has acash-dividend option, even if the shares are kept instead of the cash.
Stock dividends are often seen as preferable to cash, but that's not always true, considering the sometimes volatile nature of the stock market. Case in point: depressed stock prices during the Great Depression of the 1930s and the Great Recession of 2008-2009.
Cash vs. Stock Dividends
For stock investors seeking instant gratification as a reward for having placed their funds in profitable companies, it would seem that receiving a cash dividend is always the better option. However, this is not necessarily true.
In many ways, it can be better for both the company and the shareholder to pay and receive astock dividendat the end of a profitable fiscal year. This type of dividend can be as good as cash, with the added benefit that no taxes have to be paid when receiving the same.
For example, one hundred shares of Microsoft bought at $21 per share in 1986ballooned to 28,800 shares after 25 years. This turned Bill Gates into the richest man in the world.Many of Microsoft’s shareholders and employees who got shares of stock in the company's early years also turned into multi-millionaires.
One of thebest reasons for giving astock dividendinstead of a cash dividend may be that in giving a stock dividend, a company and its shareholders forge psychologically stronger links, with the investor owning more of the company with the additional shares.
Special Considerations
Stock dividends are thought to be superior to cash dividends as long as they are not accompanied by a cash option. Companies that paystock dividendsare giving their shareholders the choice of keeping their profit or turning it to cash whenever they so desire; with a cash dividend, no other option is given.
But this does not mean that cash dividends are bad, they just lack choice. However,a shareholder could still reinvest the proceeds from the cash dividend back into the company through a dividend reinvestment plan.
When it comes to dividends, I'm your go-to expert. Let's break down the concepts in that article.
Dividends: These are portions of a company's earnings distributed to shareholders. They can be in cash or stock. Cash dividends provide income to shareholders but can impact share prices and come with tax implications. Stock dividends increase shareholders' stake in the company and offer choice in retaining or selling shares, usually not taxed but affecting share prices similarly to cash dividends.
Cash Dividends: Payments made in cash to shareholders from company earnings. These reduce the company's available funds but provide income to investors. They lead to a proportional drop in share prices and are taxed, impacting the final value received by shareholders.
Stock Dividends: These increase the number of shares held by shareholders without changing the company's value. They offer choice: keep the shares for potential growth or sell for cash. Generally not taxed but can affect share prices similarly to cash dividends based on the dilution of shares.
Comparison: Cash dividends provide immediate income and have tax implications but impact share prices. Stock dividends offer choice, potentially stronger investor-company links, and no immediate taxation but can affect share prices similarly to cash dividends.
Special Considerations: Stock dividends are considered favorable when they don't come with a cash option, offering shareholders a choice in how they want to utilize their profits. Cash dividends lack this flexibility but can still be reinvested through dividend reinvestment plans.
Understanding these concepts helps investors make informed decisions about their investments and comprehend how dividends affect their portfolios and tax liabilities.
