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.

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Which Is Best: Cash Dividend Or Stock Dividend?

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 to shareholders of 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 key benefit 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 his or her 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 a cash-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, the Great Recession of 2008-2009 and the February 2020 selloff amid Coronavirus fears.

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 a stock dividend at 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 1986 ballooned 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 the best reasons for giving a stock dividend instead 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 pay stock dividends are 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.