The Trading Bible Trading Guides Stock Dividends - What are they and how do they work?
What are Stock Dividends?
By Vandita Jadeja, Updated on: Apr 07 2023.
A stock dividend is the distribution made by a company to its shareholders in the form of additional stock of the company. The company distributes its profits in the form of stock dividends monthly, quarterly, biannually or annually.
In this article, we will explain everything about stock dividends and help you understand how they work. Whether you are an investor or not, understanding stock dividends will help you make the right decisions going forward.
Dividends can be a part of your income every year and dividend stocks have a huge role to play in a portfolio, irrespective of your financial circumstances or your age. Let us dig deeper and understand what stock dividends can do to your portfolio.
Understanding stock dividends
A stock dividend is a payment that is made to the shareholders by a company. This payment is made in the form of additional shares of the company so it’s not a cash payment. The distribution will be made in fractions for each share you hold. Let’s say, a company issues a stock dividend of 2%, then it will pay 0.02 shares for each share you own. If you own 100 shares, you receive two additional shares.
For an investor, there is an immediate award in receiving stock dividends and there is no tax applicable until the shares are sold.
That said, a dividend issue will lead to dilution in the share price which is due to a rise in the number of shares outstanding and reduction in the ownership percentage of every shareholder. It will attract more buyers which will be beneficial for the company as well as the shareholders since they will get more rewards in the long term.
The current shareholders can choose to sell the shares right away and make the most of the immediate cash while retaining the shares they held earlier. It is a pain-free way to reward shareholders without using cash.
How does a stock dividend work?
A stock dividend is paid out whenever the company wants to reward the investors but not in the form of cash. Some companies do not have the cash to reward investors while many like to preserve it for other purposes. This is when they issue additional stock of the company. Stock dividends have a tax advantage for an investor since it is not taxed until the shares are sold.
How often do companies pay stock dividends?
Companies often pay dividends quarterly while many do pay biannually, monthly, or annually. Once the board of directors agrees on the dividend amount, the company will announce a dividend and this day is known as the declaration date.
On this date, the company will also share a date which is known as a record date when you should be a shareholder in the company to receive the dividend. If you hold the shares of the company on the record date, you will get the stock dividend. This sets the ex-dividend date which is the first day when the shareholders purchasing the stock will not be eligible to receive the declared dividend and it is usually one day before the record date.
Lastly, the payment date is the day when the dividend is distributed to the shareholders.
Example of a stock dividend
Let us assume that a company issues a 3% stock dividend. This means that the number of shares held by shareholders will increase by 3%; they will receive 3 shares for every 100 shares held. Hence, if the company has a million shares outstanding, it will mean another 30,000 additional shares. The dividend will not increase the company’s value but the share price will decrease in order to adjust for the additional shares issued.
Tips for picking stocks based on their dividends
If you want to invest in dividend stocks, you should understand how company dividends work and the different methods you can use to compare them to other companies.
Dividend per share
The dividend per share is the amount of dividend that is distributed by the company for every share of stock in a specific period. It helps to look at a company’s DPS in order to understand which company can grow their dividends over time.
Dividend yield
A very important term for investors, the dividend yield shows the company’s annual dividend by the stock price on a particular day. It gives an ideal comparison of all dividend stocks. When a $100 stock is paying a dividend of $.10 per quarter, which is $0.40 a year, then it has the same yield as a $1000 stock paying $1 each quarter and $4 annually.
The yield is the same but the amount of dividend differs. When investing in dividend stocks, comparing the yield can help make the right decision. Another thing to keep in mind is that the stock price and yield will be inversely related, so, when one goes up the other will go down. Whenever a company raises its dividend, the yield will go up and the stock price will go down.
Dividend payout ratio
Smart investors know that the easiest way to measure the dividend safety of a company is to check the payout ratio or the part of its net income which goes towards the dividend payments. So, when a company pays out 100% of its income, this means the dividend is in trouble. If the times are tough, the earnings could dip too low to cover dividends so it is advisable to look out for payout ratios that are 80% or lower than that. The dividend payout ratio will be listed on the broker's website.
Conclusion
Stock dividends are a reward to investors in kind and not cash which means that it does not have any impact on the cash reserves of the company. By declaring a stock dividend, companies can generate more interest in the stock and offer tax-free rewards to shareholders. This will help attract new investors over time. However, it will affect the share price in the near team due to the impact of dilution but this drop will only be temporary. Investing in dividend paying companies can be rewarding and helps strengthen the portfolio.
Frequently Asked Questions
What are preferred stock dividends?
A preferred stock dividend is the one paid out to the preferred shareholders and they are those who have a priority over the income of a company.
Are Stock Dividends good?
Stock dividends are good for investors since it is a tax-free reward that boosts their investment portfolio and also provides an opportunity to earn a higher dividend in the future.
How long should I hold a stock to get the dividend?
The company will announce the ex-dividend date when it announces the dividend and you must hold the stock at least one day before the ex-dividend date to get the dividend.
What are the differences between stock dividends and cash?
A stock dividend will be paid in the form of company shares while a cash dividend is paid in cash. That said, a stock dividend is not taxable until the sale of shares whereas a cash dividend is taxable.