Investors have different goals while investing in stocks of companies. While some may invest their money for capital appreciation, others stay invested for predictable returns in the form of dividends. However, it is important to note that dividends are not always paid in cash because of several reasons outlined subsequently in this article. Corporates may reward their shareholders in the form of stock dividends. Therefore, stock dividends are a way of distributing wealth to a company’s shareholders in the form of additional stocks instead of cash payments.
Dividends are usually paid in the form of cash to shareholders. But there could be situations when a company is short on cash and would want to keep the cash reserves from profits for itself. Also, companies may prefer to build cash reserves for reinvestment in business instead of sharing profits with shareholders. In such cases, the company may choose to pay its existing shareholders in the way of additional stocks. Usually, only companies with robust financials pay dividends, but due to market conditions, they may experience a slowdown in profits and cash inflow due to which they choose to go the route of stock dividends. Let us understand what are stock dividends and how stock dividends work. Also, let us find out the advantages and disadvantages of stock dividends.
How do Stock Dividends Work?
You can understand how stock dividends work by the following example. Suppose, company X has 100,000 outstanding shares in the market and declares a 10% stock dividend. Therefore, the company has to issue an additional 10,000 shares taking the total number of shares outstanding to 110,000. If investor A owns 100 shares of company X, the declaration of 10% stock dividends will result in an additional 10 shares credited to him. In other words, investor A will now own 110 shares of company X. Stock dividends could be paid quarterly or annually based on company policies.
Stock dividends function in a very similar way to cash dividends or stock splits and they do not affect the overall market capitalization of the company. Considering the previous example, suppose company X had 100,000 outstanding shares worth ₹50,00,000 at ₹50 per share, the declaration of 10% stock dividends results in additional shares of 10,000 bringing the overall number of outstanding shares to 110,000. Since the market capitalization of the company remains unchanged, the revised share price will be ₹50,00,000/110,000 = ₹45.45. Therefore, though investor A now owns more shares, the value of his equity in company X does not change.
In India, stock dividends are usually paid on a pro-rata basis. So, if company X issues dividends in the form of stocks on a 1:10 basis, then it will credit an additional ten shares for every share held by its existing shareholders. Stock dividends are declared on a day known as the declaration date. Investors will receive stock dividends if they purchase shares of the company by the record date. If shares are bought on or after the record date by investors, those investors will not be eligible for the next cycle of stock dividends. On the “record date,” the company reviews its records to identify which shareholders are eligible for dividends. Usually, there is also something known as “ex-dividend date” which is the first day when stocks are traded without any benefit or corporate action. Investors need to buy stocks of a company before the record date if they want to be considered for dividend payments.
Advantages of Stock Dividends
There are several advantages of stock dividends for companies as well as investors some of which are mentioned below -
Maintains liquid cash reserves
The primary benefit of issuing stock dividends is that a company does not have to allocate its profits to cash dividends. This helps the company compensate its existing shareholders without exhausting its cash reserves. The company can thus use stock dividends to maintain and increase its cash positions that can be used for capital investments in business as well as paying off short-term or long-term obligations.
Provides tax advantages
Individual shareholders can realize tax benefits by holding stock dividends. There is no tax liability on stock dividends as there is no financial transaction. An increase in the networth of an investor due to additional stocks is treated as a capital gain and is not taxed unless the investor sells those shares for a profit. Based on the duration of the shareholding by investors, the application STCG or LTCG tax rate is applicable. This is very different from cash dividends because there is 10% TDS applicable on dividend payments above ₹5000.
Builds a positive image
Though not as attractive as cash dividends, stock dividends can still build a perception of stable financial health of a company. Therefore, it serves as a positive signaling mechanism to prospective investors who are willing to invest in financially robust companies.
Makes stocks affordable
Since stock dividends do not affect the market capitalization of the company, the issuance of additional stocks results in a reduction of price per share. This can make the company’s share price seem to be more affordable for investors. For instance, if the price per share of company M and company N are ₹10,000 and ₹30,000 respectively and an investor has ₹20,000 to invest, then company M would seem to be more affordable at ₹10,000 per share.
Disadvantages of Stock Dividends
Some disadvantages of stock dividends are as follows -
No monetary benefit for investors
Unlike cash dividends, stock dividends do not carry any immediate financial benefits for shareholders which may turn off many investors. Shareholders can only receive long-term benefits from stock dividends if the stock price appreciates in value. A loss in the share price can result in a negative return for shareholders.
Share value dilution
Issuing stock dividends always results in the dilution of a company's share value in the short-term because the overall market capitalization is unaffected. As the supply of outstanding shares increases because of stock dividends without affecting the market capitalization, the price per share always goes down.
Misinterpretation by shareholders
Declaration of stock dividends may cause negative perceptions among shareholders as it can be seen as a sign of financial distress. Shareholders may interpret stock dividends as utilization of cash reserves for risker capital expansion projects by a company.
Increased compliance
Cash dividends usually attract a tax deducted on source on dividend amounts greater than ₹5000 and shareholders do not have to worry about tax compliance issues. However, in case of stock dividends, there is no upfront tax liability but individuals have to pay taxes if they realize profits after selling those shares. Again, the tax liability is determined on the basis of the holding period of those shares. So, shareholders have to keep a record of the stock dividend payment date, stock selling data, and the amount of gain realized in order to calculate their tax liability. This results in more record-keeping for shareholders for compliance.
Real-World Examples of Stock Dividends
Multiple real-world examples of stock dividends exist. Some of the leading public sector companies in India such as Power Grid Corporation, Metal Scrap Trade Corporation, Coal India, and others pay dividends to their existing shareholders. Automotive giants such as Hero Motocorp and Ashok Leyland also handsomely reward their shareholders through dividends. Infosys and HCL Technologies in the IT sector also have a high dividend payment ratio. While major players in a sector usually declare cash dividends, it is not uncommon for them to declare stock dividends if they want to keep significant cash for future expansion plans.
Stock dividends provide an opportunity to investors to cash out their stocks at a higher price in the future, resulting in capital gains. In a way, stock dividends can be converted into cash not immediately but at a future date. Investors who are looking forward to investing in stable companies can do so by opening a stock broking account.
