Cash and stock dividends offer discrete benefits to the issuing company and its shareholders.
Let us discuss what are cash and stock dividends and their key differences.
What is a Cash Dividend?
A cash dividend is an income that investors (shareholders) receive from a company in cash form.
Cash dividends are paid out of a company’s cash reserves. Although a company can use other sources of reserves for dividend payments, using cash reserves is the most common practice for companies.
Dividends are a preferable source of income for investors looking for consistent income. Most established companies offer a consistent and long-term dividend policy that attracts income-seeking investors.
Cash dividends are more common than stock dividends. As most investors expect a consistent stream of income, they prefer cash dividends.
Companies with an established history and accumulated profits also prefer cash dividends. However, liquidity is a major concern for these companies as they often accumulate profits but lack cash.
On the other hand, companies struggling with growth issues or liquidity, do not offer cash dividends. They prefer to keep cash for growth investments and offer stock dividends
What are the implications of a Cash Dividend for Investors?
Investors seeking income sources prefer cash dividends. They invest in companies that offer a consistent or growth dividend policy to receive confirmed earnings every year.
When companies issue cash dividends, it reduces the stock prices. It is for the fact that a company is only sharing the total accumulated economic value of the company with its shareholders.
In simple words, a company is distributing what is already earned by the company. These earnings would have already been reflected in the share prices.
Therefore, when a company issues cash dividends, its stock prices fall.
Also, when investors receive cash dividends, they are not reinvesting their income. In the long-term, that can deplete their investments against inflation.
When investors receive qualified dividends, they enjoy lower income tax rates. Otherwise, the tax bracket for cash and stock dividends will be the same.
Another benefit of receiving cash dividends is that these are virtually risk-free. Cash dividends are paid out consistently and do not offer any investment risks.
Cash dividends are common and investors feel a familiar experience. Thus, cash dividends are a popular choice for most companies and in many sectors.
Implications of a Cash Dividend for the Company
A cash dividend results in a decreased stock price of the company temporarily. As mentioned above, it is for the fact that a company shares the accumulated economic value with its shareholders.
In the long-term, a cash or a stock dividend should not impact the share price of a company.
In the absence of positive NPV investment options, a cash dividend is considered a useful alternative as well. Companies shouldn’t hoard cash when they cannot invest it anyway.
One drawback of offering cash dividends is the signaling effect for the company and its share value.
When a company keeps paying a cash dividend, it sends a positive market signal to investors and analysts.
However, keeping up with the expectations of the shareholders can be costly. If a company pays a lower cash dividend or does not pay at all, it sends a negative signal to the market.
Thus, a company needs to choose a dividend policy that is sustainable for the long run.
Also, paying a cash dividend makes a company indifferent between paying back to shareholders and utilizing cash reserves for internal growth.
If a company keeps a consistent dividend policy, it may have to borrow money to pay cash dividends that may incur interest costs.
What is a Stock Dividend?
A stock dividend is a dividend paid in the form of additional shares rather than cash.
A company may decide to pay dividends to its shareholders but keep cash reserves. It would then decide to issue new shares to its existing shareholders replacing cash dividends.
As the company issues new shares, its share prices fall. The total market capitalization of the company remains the same though.
For example, if a company had 1 million shares in issue and it decides to pay a 10% dividend in stocks, it will issue 100,000 new shares. If the share price was previously valued at $20, the new share price will fall to $18.18.
The total market capitalization of the company in both cases would be the same; $ 20 million. However, this is a theoretical interpretation of stock dividends and the impact on share prices.
Theoretically, a stock dividend should not affect the share prices of a company. However, the signaling effect may cause a temporary fall in the share price of the company issuing stock dividends.
Stock dividends are a useful alternative to cash dividends. However, these are less common in practice and offer some risks for shareholders.
What are the implications of a Stock Dividend for Investors?
Stock dividends offer some discrete benefits to shareholders.
The biggest advantage of stock dividends is the choice for shareholders. Shareholders receive new shares in proportion to their existing shareholding in the company.
They can choose to keep the newly received shares for the long term. It means they can reap the rewards of capital gains in the long run.
If shareholders wish to receive cash, they can sell newly received shares. Thus, choosing an alternative of cash dividends.
When shareholders keep stock dividends and do not convert them to cash, they do not incur a tax obligation. Therefore, stock dividends offer a tax advantage for some shareholders as well.
Stock dividends have a few drawbacks for the shareholders too.
Shareholders would lose their proportional shareholding in the company if they sell stock dividends and convert them into cash.
Secondly, as soon as they sell stocks, they’ll incur taxes. So the tax benefit vanishes when shareholders choose the conversion.
Stock dividends also carry performance risk. If the company does not perform well, its share prices will fall which would eventually lower shareholders’ return from stock dividends.
Implications of a Stock Dividend for the Company
Stock dividends are uncommon but a useful option for many companies. Most companies pay cash dividends; however, some companies offer stock dividends for several reasons.
Usually, a company issues stock dividends when it is short of cash or facing liquidity challenges. It also has to keep shareholders satisfied. Therefore, stock dividends are a useful option that satisfies both of these purposes for the company.
If a company wants to utilize the cash reserves for internal growth purposes, it can keep cash reserves and issue new shares as stock dividends.
Issuing a stock dividend shouldn’t impact the share prices of the company for a long time. However, if stock dividends are issued by a company usually issuing cash dividends, it may send a negative signal to the market.
Shareholders would also be skeptical about a stock dividend rather than a cash dividend. For shareholders, the investment growth prospects would be tied with the performance of the company.
In short, if a company follows a consistent stock dividend policy it offers a few benefits to both shareholders and the company.
On the other hand, if it is a one-time event, it may offer some disadvantages to shareholders and the company too.
Cash Dividend Vs Stock Dividend – Key Differences
As mentioned above, when a company chooses one dividend policy consistently, it should offer discrete benefits to shareholders and the company.
A cash dividend is a more common and regular choice for companies and shareholders. Shareholders receive cash and enjoy a consistent income stream.
A stock dividend offers a choice to shareholders. They can retain additional stocks for long-term growth and capital gains or sell them to convert them into cash.
Cash dividends do not come with investment or any other type of risk. Stock dividends offer some risks to investors as the share prices of the company may fall after issuing stock dividends.
From the issuing company’s perspective, the choice depends on the availability of cash.
If a company is facing liquidity challenges and still needs to issue dividends, stock dividends offer a better option.
A company can also borrow money to issue cash dividends. However, that would incur additional interest costs on top of the dividend issuing costs. Also, it would increase the gearing level of the company.
Investors do not have a choice between receiving a cash or stock dividend as it is the decision of the company. The consequences for shareholders depending on their investment goals.
Shareholders looking for an income stream would prefer cash dividends. Contrarily, investors looking for growth investments would prefer stock dividends.
Also, stock dividends offer added flexibility of choice of conversion for shareholders.
