Value of investors of stock dividends and stock splits


Theoretically, a stock dividend or stock is not a thing of value to investors. They receive ownership of additional shares of common stock, but their proportionate ownership of the company is unchanged. The market price of the stock should decline proportionately, so that the total value of each shareholder’s holdings stays the same. To illustrate with a stock dividend, suppose that you held 100 shares of common stock worth $40 per share or $4,000 in total. After a 5 percent stock dividend, share price should drop to $38.10($40/1.05). The total value of your holding however, would still be worth $4,000($38.10 x 105 shares). Under these conditions the stock dividend does not represent a thing of value to you. You merely have a greater number of shares of stock evidencing the same ownership interest. In theory, the stock dividend or split is a purely cosmetic change.

To the extent that an investor wishes to sell a few shares of stock for income, the stock dividend / split may make it easier to do so. Without the stock dividend / split, of course, shareholders could also sell a few shares of their original holdings for income. In either case, the sale of stock represents the sale of principal and is subject to the capital gains tax. It is probable that certain investors do not look at the sale of additional stock resulting from a stock dividend / split as a sale of principal. To them, the stock dividend / split represent a windfall gain. They can sell the additional shares and still retain their original holdings. The stock dividend / split may have a favorable psychological effect on these shareholders.

Effect on Cash Dividends:

The stock dividend or stock split may be accompanied by an increased cash dividend. For the former, suppose that an investor owns 100 shares of a company paying a $1 annual dividend. The company declares a 10 percent stock dividend and, at the same time, announces that the cash dividend per share will remain unchanged. The investor will then have 110 shares, and the total cash dividends will be $110 rather than $100, as before. In this case, a stock dividend increases the total cash dividends. Whether this increase in cash dividend has a positive effect on shareholder wealth will depend on the trade-off between current dividends and the retention of earnings, which we discussed earlier. Clearly, the stock dividend I this case represents a decision by the firm to moderately increase the amount of cash dividends. However, the firm does not need the stock dividend to do so. The firm could merely increase its cash dividend per share from $1 to $1.10.

Sometimes a stock dividend is employed to conserve cash. Instead of increased the cash dividend as earnings rise, a company may desire to retain a greater portion of its earnings and declare a modest stock dividend. This decision effectively amounts to lowering the dividend-payout ratio: as earnings rise and the dividend remains approximately the same, the dividend-payout ratio will decline. Whether shareholder wealth is increased by this action will depend on considerations previously discussed. The decision to retain a higher proportion of earnings, of course, could be accomplished without a stock dividend. Although the stock dividend may tend to please certain investors by virtue of its psychological impact, the substitution, of common stock for cash dividends involves a sizable administrative cost. Stock dividends are simply much more costly to administer than are cash dividends. This out-of-pocket expense works to the disadvantage of stock dividends.