Every corporation has the same goal in mind — to maximize shareholder wealth. This goal is fulfilled in two different 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, a shareholder will receive cash based on the 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, then the investor would receive $2,500 as a cash dividend.
What Happens When a Stock Dividend is Paid
On the other hand, if an investor still owns the same 10,000 shares, but the company declares a stock dividend of 0.2, this would mean that for every share owned, 0.2 of a share (called a fractional share) is "paid" to the shareholder. So, for our investor with 10,000 shares, after the dividend was collected they would own 12,000 shares (10,000 x 1.2). The effect of this stock dividend on the stock price, however, may not be as positive.
Stock Split Dilution
The stock dividend increases (like a stock split) the number of shares outstanding, and with all other things remaining the same, the stock price will fall. Therefore, the stock price would dilute from either a stock dividend or a stock split. Stock prices are based on the value of the firm divided by the number of shares outstanding.
For example, say there is a firm with 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, then the number of shares outstanding will increase by 20 percent to 240 million. With this new number of shares outstanding the company's market cap remain the same, but the share price will now decrease to $3.13 ($750/240).
What Happens When a Stock Splits
Conversely, the same results would occur if the firm decided to split the stock 6:5, which means that for every five shares currently owned, the shareholders will receive 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 split as they did before.
(If you are interested in learning more about dividends, read How and Why Do Companies Pay Dividends?)