Complete Guide To Corporate Finance

Dividends - Stock Dividends And Stock Splits

Like cash dividends, stock dividends and stock splits also have effects on a company's stock price. Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. For example, suppose Newco decides to issue a 10% stock dividend. Each current stockholder will thus have 10% more shares after the dividend is issued.

Stock Splits
Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.

Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company's stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. The split will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares. For example, a shareholder owning 2,000 shares out of 100,000 before a stock split would own 4,000 shares out of 200,000 after a stock split.

Stock Split Example:
Suppose Newco's stock reaches $60 per share. The company's management believes this is too high and that some investors may not invest in the company as a result of the initial price required to buy the stock. As such, the company decides to split the stock to make the entry point of the shares more accessible.

For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they own, all holders of Newco stock will receive two Newco shares priced at $30 each, and the company's shares outstanding will double. Keep in mind that the company's overall equity value remains the same. Say there are one million shares outstanding and the company's initial equity value is $60 million ($60 per share x 1 million shares outstanding). The equity value after the split is still $60 million ($30 per share x 2 million shares outstanding).

While stock prices will most likely rise after a split or dividend (remember price increases are caused by positive signals a company generates with respect to future earnings), if positive news does not follow, the company's stock price will generally fall back to its original level. Some investors think that stock splits and stock dividends are unnecessary and do little more than create more stocks. (For further reading on stock splits, see
Berkshire's Stock Splits: Good Buy or Goodbye? and Top Stock Target Price Misfires.)

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