Every corporation has the same goal in mind—to maximize shareholder wealth. This goal is fulfilled in either of two ways, by reinvesting cash into the business to stimulate its growth or by paying dividends to shareholders. A dividend can take the form of either cash or stock.
In the case of a cash dividend, shareholders receive a payment in cash that is based on the number of shares they own. Let's say a corporation declares a cash dividend of $0.25 per share. If an investor owns 10,000 shares, the investor would receive $2,500 as a cash dividend.
- Both a stock dividend and a stock split dilute the price of the share price.
- In either case, the result is a larger number of stock shares outstanding.
- The ownership stake of the shareholder, however, remains the same.
On the other hand, if the company declares a stock dividend of 0.2, the shareholder's payment comes in the form of stock shares. In this case, for every share owned, 0.2 of a share (called a fractional share) is awarded to the shareholder. Thus, the investor with 10,000 shares would own a total of 12,000 shares (10,000 x 1.2) after collecting the dividend.
The effect of this stock dividend on the stock price, however, is not as positive, at least immediately.
Cash Dividend Vs. Stock Dividend
The stock dividend increases the number of shares outstanding, just as a stock split does. With all other things remaining the same, the stock price will fall.
Therefore, a stock dividend and a stock split both dilute the stock's price.
Stock prices are based on the value of the firm divided by the number of shares outstanding. For example, say a firm has a market cap of $750 million, and there are 200 million shares outstanding at the stock price of $3.75 ($750/200). If there is a stock dividend declared of 0.2, the number of shares outstanding will increase by 20% to 240 million.
With this new number of shares outstanding, the company's market cap remains the same, but the share price will decrease to $3.13 ($750/240).
A cash dividend does not dilute share price. It counts against the company's bottom line.
What Happens When a Stock Splits
The result would be the same if the firm decided to split the stock 6:5, which means that for every five shares currently owned, the shareholders will own a total of six shares of stock after the split.
The number of shares outstanding would increase to 240 million (200 x 1.2), and the market price would be diluted to $3.13.
One positive characteristic of the stock dividend and stock split is that ownership is not further diluted. That is to say, all shareholders will own the same proportionate amount of the company after the dividend or the split as they did before.
It should be noted that this dilution is the immediate effect of a stock dividend. The payment is intended as a reward to shareholders and is made with the assumption that the stock price will continue to rise and the stockholders will reap the rewards.