Loading the player...
A:

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.

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.

What Is a Stock Dividend?

A stock dividend, on the other hand, is an increase in the amount 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 amount of shares by 5% (1 share for every 20 owned). If there are 1 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.

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 is 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.

Stock dividends are thought to be superior to cash dividends as long as they are not accompanied with 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.

Opting for stock dividends is not always better than taking the cash due to the sometimes unpredictable nature of the stock market. Oct. 24,1929 will forever be remembered as the start of the Great Depression, the first day of a stock market collapse that crippled the United States for the next several years. Just days before, the Dow Jones appeared rock solid. During the Depression, most shares of stock were not worth the paper on which the stock certificates were printed.

(For further reading, see How And Why Do Companies Pay Dividends? and Dividend Reinvestment Plans - Are They for You?)

RELATED FAQS
  1. How do dividends affect retained earnings?

    Find out how distribution of dividends affects a company's retained earnings, including the difference between cash dividends ... Read Answer >>
  2. Where exactly do dividends come from?

    Learn about sources of cash dividend, such as operational, financing and investing cash flows, as well as issuances of new ... Read Answer >>
  3. Can I receive dividends on ordinary shares of a company?

    Understand the basics of collecting dividend payments on ordinary shares, including when dividends can be paid and under ... Read Answer >>
Related Articles
  1. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  2. Financial Advisor

    How Mutual Funds Pay Dividends: An Overview

    The process by which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Here's a look.
  3. Investing

    Introduction To Dividends

    Investing in dividend-paying stocks can be an effective method of building long-term wealth.
  4. Investing

    Dividend Facts You May Not Know

    Discover the issues that complicate these payouts for investors.
  5. Investing

    The Risks of Chasing High Dividend Stocks

    Dividend stocks offer enticing yields, but a lot can go wrong on the way to collecting that dividend payout.
  6. Investing

    Dividend Yield For The Downturn

    High-dividend stocks make excellent bear market investments, but the payouts aren't a sure thing.
  7. Investing

    5 Dividend Growth Stocks Posed For Higher Dividends (V, NKE)

    Learn about five companies that have a strong history of consistently growing their dividend payments and have the potential to continue doing so in the future.
  8. Investing

    4 Ratios to Evaluate Dividend Stocks

    Discover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
RELATED TERMS
  1. Dividend

    A dividend is a distribution of a portion of a company's earnings, ...
  2. Dividend Policy

    The policy a company uses to decide how much it will pay out ...
  3. Property Dividend

    An alternative to cash or stock dividends. A property dividend ...
  4. Dividend Frequency

    Dividend frequency is how often a dividend is paid by an individual ...
  5. Constructive Dividend

    A concept in U.S. taxation in which various distributions to ...
  6. Indicated Dividend

    The total dividends that would be paid on a share of stock throughout ...
Hot Definitions
  1. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, ...
  2. Moving Average - MA

    A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out ...
  3. Stop Order

    A stop order is an order to buy or sell a security when its price increases past a particular point in order to limit losses ...
  4. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
  5. Candlestick

    A chart that displays the high, low, opening and closing prices for a security for a single day. The wide part of the candlestick ...
  6. Indicator

    Indicators are statistics used to measure current conditions as well as to forecast financial or economic trends.
Trading Center