Cash dividends, as the name implies, are payments made to shareholders in cash. They come in three forms:
1 . Regular dividends occur when a company pays out a portion of profits on a consistent schedule (e.g., quarterly). A long-term record of stable or increasing dividends is widely viewed by investors as a sign of a company’s financial stability.
2 . Special dividends are used when favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays. Many cyclical firms (e.g., automakers) will use a special dividend to share profits with shareholders when times are good but maintain the flexibility to conserve cash when profits are down. Other names for special dividends include extra dividends and irregular dividends.
3. Liquidating dividends occur when a company goes out of business and distributes the proceeds to shareholders. For tax purposes, a liquidating dividend is treated as a return of capital and amounts over the investor’s tax basis are taxed as capital gains.
No matter which form cash dividends take, their net effect is to transfer cash from the company to its shareholders. The payment of a cash dividend reduces a company’s assets and the market value of its equity. This means that immediately after a dividend is paid, the price of the stock should drop by the amount of the dividend. For example, if a company’s stock price is $25 per share and the company pays $ 1 per share as a dividend, the price of the stock should immediately drop to $24 per share to account for the lower asset and equity values of the firm.
Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. Stock dividends are commonly expressed as a percentage. A 20% stock dividend means every shareholder gets 20% more stock.
Stock splits divide each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner’s wealth. Splits are expressed as a ratio. In a 3-for-1 stock split, each old share is split into three new shares. Stock splits are more common today than stock dividends.
The bottom line for stock splits and stock dividends is that they increase the total number of shares outstanding, but because the stock price and earnings per share are adjusted proportionally, the value of a shareholder’s total shares is unchanged. Some firms use stock splits and stock dividends to keep stock prices within a perceived optimal trading range of $20 to $80 per share.
What does academic research have to say about this?
– Stock prices tend to rise after a split or stock dividend.
– Price increases appear to occur because stock splits are taken as a positive signal from management about future earnings.
– If a report of good earnings does not follow a stock split, prices tend to revert to their original (split-adjusted) levels.
– Stock splits and dividends tend to reduce liquidity due to higher percentage brokerage fees on lower-priced stocks.
The conclusion is that stock splits and stock dividends create more shares but don’t increase shareholder value.
Reverse stock splits are the opposite of stock splits. After a reverse split, there are fewer shares outstanding but a higher stock price. Because these factors offset one another, shareholder wealth is unchanged. The logic behind a reverse stock split is that the perceived optimal stock price range is $20 to $80 per share, and most investors consider a stock with a price less than $5 per share less than investment grade. Exchanges may impose a minimum stock price and delist those that fall below that price. A company in financial distress whose stock has fallen dramatically may declare a reverse stock split to increase the stock price.
Effects on Financial Ratios
Paying a cash dividend decreases assets (cash) and shareholders’ equity (retained earnings). Other things equal, the decrease in cash will decrease a company’s liquidity ratios and increase its debt-to-assets ratio, while the decrease in shareholders’ equity will increase its debt-to-equity ratio.
Stock dividends, stock splits, and reverse stock splits have no effect on a company’s leverage ratios or liquidity ratios. These transactions do not change the value of a company’s assets or shareholders’ equity; they merely change the number of equity shares.
Dividend Payment Chronology
– Declaration date. The date the board of directors approves payment of the dividend.
– Ex-dividend date. The first day a share of stock trades without the dividend. The ex-dividend date is also the cutoff date for receiving the dividend and occurs two business days before the holder-of-record date. If you buy the share on or after the ex-dividend date, you will not receive the dividend.
– Holder-of-record date. The date on which the shareholders of record are designated to receive the dividend.
– Payment date. The date the dividend checks are mailed out or when the payment is electronically transferred to shareholder accounts.
Stocks are traded ex-dividend on and after the ex-dividend date, so stock prices should fall by the amount of the dividend on the ex-dividend date. Because of taxes, however, the drop in price may be closer to the after-tax value of dividends.