There are a variety of tactics that investors can employ when investing in stocks in an effort to increase their returns.
Purchasing stocks that give dividends—regular payments made by an organization to its shareholders—is one of these tactics. But not all dividends are made equal, and the stock dividend is one that investors tend to favor more than others.
What is a Stock Dividend?
A distribution of extra shares of stock to current shareholders is known as a stock dividend. A cash dividend is a payment of money to stockholders; this is not the same. A company’s stock dividend raises the number of outstanding shares, but it has no impact on the company’s overall worth or the value of each individual share.
Consider a business with 1 million outstanding shares that are presently trading at $100 each. The business chooses to distribute a 10% stock dividend, which entitles shareholders to receive an extra share for every 10 shares they currently own. An investor will acquire 10 extra shares, increasing their total to 110, if they currently own 100 shares. The price per share will change as necessary, but the investor’s shares’ overall value will stay the same. The business will still be in possession of 1.1 million shares after the stock dividend, but the share price will fall to $91.09.
Why Do Companies Issue Stock Dividends?
There are numerous causes why businesses distribute stock dividends. To reward shareholders without using currency is one frequent justification. A stock dividend can be a good way for a business to give shareholders value even though it is cash-strapped. Companies may also distribute equity dividends to inform investors that they are doing well and anticipate doing so in the future. Finally, since there are more shares available for trading, stock dividends can help to increase liquidity in the company.
Types of Stock Dividends
Small stock dividends and large stock dividends are the two major categories of stock dividends. Generally speaking, a small stock dividend is one that represents less than 25% of the existing shares. It is typically not necessary for a business to report any income or gain on a distribution of small stock dividends. Rather, the cost basis of the shares is changed to represent the addition of the new shares.
A big stock dividend, on the other hand, is one that represents more than 25% of the outstanding shares. The fair market worth of the shares distributed when a business distributes a sizable stock dividend must be recorded as income or gain. The fair market worth of the newly acquired shares is also taken into account when adjusting the cost basis of the shares.
Tax Implications of Stock Dividends
Stock dividends are typically handled the same as cash dividends in terms of taxes. They are therefore typically taxable as ordinary revenue in the year of receipt. There are a few exceptions to this guideline, though. For instance, a small stock dividend is typically exempt from being taxed as revenue. A stock dividend that is a return of capital is also usually not taxable as income, though it may lower the shares’ cost basis.
Advantages of Stock Dividends
Stock dividends offer several advantages to investors, including:
- Tax Benefits: Stock dividends can provide tax benefits to investors, particularly in the case of small stock dividends and stock dividends that are a return of capital, which are generally not taxable as income. This can be a significant advantage for investors who are looking for ways to reduce their tax liability.
- Increased Investment: Stock dividends allow investors to increase their investment in the company without having to put in additional capital. This can be particularly beneficial for investors who are looking to build a long-term investment portfolio or those who want to reinvest their profits back into the company.
- Positive Signal: Companies that issue stock dividends can send a positive signal to investors about their financial health and future prospects. By issuing a stock dividend, the company is essentially indicating that it has sufficient cash flow and profits to distribute to shareholders while continuing to invest in growth and expansion.
- Stable Income Stream: Stock dividends can provide a stable income stream for investors, particularly for those who are looking for regular income from their investments. While cash dividends can be subject to fluctuation, stock dividends can provide a more stable income stream over the long term.
- Higher Yield: In some cases, stocks that pay dividends can offer a higher yield than other investments, particularly in a low-interest-rate environment. This can make them an attractive option for investors who are looking for higher returns on their investment.
Disadvantages of Stock Dividends
- Dilution: The issuance of stock dividends can lead to dilution of existing shares, which can have a negative impact on the value of individual shares. When a company issues new shares, the ownership stake of existing shareholders is reduced, which can decrease the value of their investment.
- Lack of Flexibility: Stock dividends are generally non-negotiable and non-optional. Shareholders receive additional shares automatically, which can limit their flexibility in terms of managing their investment portfolio.
- Market Perception: Although stock dividends can send a positive signal to investors about the company’s financial health, they can also be viewed negatively by some investors who prefer that the company use its cash reserves to invest in growth and expansion rather than distributing profits to shareholders.
Stock dividends are a useful instrument for investors because they allow them to acquire more shares without making any additional investments. However, it’s crucial to comprehend the various stock dividend types and the related tax consequences. Investors can then decide for themselves whether to buy stocks that pay dividends and which kind of dividend is best for their investment plan.