What is a Stock Dividend?
A stock dividend, a method used by companies to distribute wealth to shareholders, is a dividend payment made in the form of shares rather than cash. Stock dividends are primarily issued in lieu of cash dividends when the company is low on liquid cash on hand. The board of directors decides on when to declare a (stock) dividend and in what form the dividend will be paid.
Impact of a Stock Dividend on Market Capitalization
Similar to a cash dividend, a stock dividend does not increase shareholder wealth or market capitalization. Although it increases the number of shares outstanding for a company, the price per share must decrease accordingly. An understanding that the market capitalization of a company remains the same explains why share price must decrease if more shares are issued. The following diagram illustrates the concept:
Example of a Stock Dividend
Colin is a shareholder of ABC Company and owns 1,000 shares. The board of directors of ABC Company recently announced a 10% stock dividend. Assuming that the current stock price is $10 and there are 100,000 total shares outstanding, what is the effect of a 10% stock dividend on Colin’s 1,000 shares?
1. Determine the market capitalization of ABC Company:
$10 x 100,000 shares = $1,000,000 (market capitalization)
2. Determine the increase in shares outstanding due to a 10% stock dividend:
100,000 shares x 10% = 10,000 increase in shares outstanding
3. Determine the new total shares outstanding:
10,000 + 100,000 = 110,000 shares
4. Determine the number of shares Colin now owns:
Before the stock dividend, Colin owned 1% (1,000 / 100,000) of the total outstanding shares. Since a stock dividend is given to all shareholders, Colin’s ownership percentage in ABC Company remains the same.
Therefore, Colin would own 1% of the new total shares outstanding or 1% x 110,000 = 1,100. The number is identical to increasing Colin’s 1,000 shares by the 10% stock dividend.
5. Determine the price per share of ABC Company:
A stock dividend does not increase the market capitalization of a company. The market capitalization of ABC Company remains $1,000,000. With 110,000 total shares outstanding, the stock price of ABC Company would be $1,000,000 / 110,000 = $9.09.
The following diagram illustrates the impact of a stock dividend on Colin:
The following diagram illustrates the impact of a stock dividend on ABC Company:
The key takeaway from our example is that a stock dividend does not affect the total value of the shares that each shareholder holds in the company. As the number of shares increases, the price per share decreases accordingly because the market capitalization must remain the same.
Advantages of a Stock Dividend
1. Maintaining cash position
A company that does not have enough cash may choose to pay a stock dividend in lieu of a cash dividend. In other words, a cash dividend allows a company to maintain its current cash position.
2. Tax considerations for a stock dividend
No tax considerations exist for issuing a stock dividend. For this reason, shareholders typically believe that a stock dividend is superior to a cash dividend – a cash dividend is treated as income in the year received and is, therefore, taxed.
3. Maintaining an “investable” price range
As noted above, a stock dividend increases the number of shares while also decreasing the share price. By lowering the share price through a stock dividend, a company’s stock may be more “affordable” to the public.
For example, consider an investor with $1,000 looking to invest in Stock A or Stock B. Stock A is priced at $2,000 while Stock B is priced at $500. Stock A would be deemed “unaffordable” for the investor since he only has $1,000 to invest.
Disadvantages of a Stock Dividend
1. Market signaling and asymmetric information
The market may perceive a stock dividend as a shortage of cash, signaling financial problems. Market participants may believe the company is financially distressed, as they do not know the actual reason for management issuing a stock dividend. This can put selling pressure on the stock and depress its price.
2. Risky projects
Issuing a stock dividend instead of a cash dividend may signal that the company is using its cash to invest in risky projects. The practice can cast doubt on the company’s management and subsequently depress its stock price.
Journal Entries for a Stock Dividend
The journal entries for a stock dividend depends on whether the company is involved in a small stock dividend or a large stock dividend. The journal entries for both sizes are illustrated below:
1. Small dividend
A stock dividend is considered a small stock dividend if the number of shares being issued is less than 25%. For example, assume a company holds 5,000 common shares outstanding and declares a 5% common stock dividend. In addition, the par value per stock is $1, and the market value is $10 on the declaration date. In this scenario, 5,000 x 5% = 250 new common shares will be issued. The following entries are made:
2. Large dividend
A stock dividend is considered a large stock dividend if the number of shares being issued is greater than 25%. For example, assume a company owns 5,000 common shares outstanding and declares a 50% common stock dividend. In addition, the par value per stock is $1, and the market value is $10 on the declaration date. In such a scenario, 5,000 x 50% = 2,500 new common shares will be issued. The following entries are made:
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