Foundations of Financial Management: An Analysis (part 71)

A dream doesn't become reality through magic; it takes sweat, determination and hard work.

Colin Powell

Dividend Policy and Retained Earnings

(part C)

by

Charles Lamson

Stock Dividend

A stock dividend represents a distribution of additional shares to common stockholders. The typical size of such dividends is in the 10 percent range, so a stockholder with 10 shares might receive one new share in the form of a stock dividend. Larger distribution of 20 to 25 percent or more are usually considered to have the characteristics of a stock split, a topic to be discussed in the next post.

Accounting Considerations for a Stock Dividend

Assume that before the declaration of a stock dividend, the XYZ Corporation has the net worth position indicated in Table 3.

Table 3   XYZ Corporation's financial position before stock dividend

If a 10 percent stock dividend is declared, shares outstanding will increase by 100,000 (10% x 1 million shares). An accounting transfer will occur between retained earnings and the two capital stock accounts based on the market value of the stock dividend. If the stock is selling at $15 a share, we will assign $1 million to common stock (100,000 shares X $10 par) and $500,000 to capital in excess of par. The latter value is based on 100,000 new shares x ($15 - $10) , or $5. In the calculation in parentheses, we subtracted par value from the market value. The net worth proposition position of XYZ after the transfer is shown in Table 4.

Table 4 XYZ Corporation's financial position after stock dividend

Value to the Investor

An appropriate question might be: Is a stock dividend of real value to the investor? Suppose a group of people collectively purchased $1,000 worth of assets and issued 10 shares of stock to each person. Three days later it is announced that each stockholder will receive an extra share. Has anyone benefited from the stock dividend? Of course not! The asset base remains the same ($1,000), and proportionate ownership in the business is unchanged (everyone got the same new share). They merely have more paper to tell them what they already knew.

The same logic is essentially true in the corporate setting. In the case of the XYZ Corporation shown in Tables 3 and 4 we assumed 1 million shares were outstanding before the stock dividend and 1.1 million shares afterward. Now let us assume the corporation had aftertax earnings of $6.6 million. Without the stock dividend, earnings per share would be $6.60, and with the dividend $6.00.

Earnings per share have gone down by exactly the same percentage that shares outstanding increased. For further illustration assuming that Stockholder A had 10 shares before the stock dividend and 11 afterward, what are his or her total claims to earnings? As expected, they remain the same, at $66.

Claim to earnings = Shares X Earnings per share

Without stock dividend: 10 X $6.60 = $66

With stock dividend: 11 X $6.00 = $66

Taking the analogy one step further, assuming the stock sold at 20 times earnings before and after the stock dividend, what is the total market value of the portfolio in each case?

The total market value is unchanged. Note that if the stockholder sells the 11th share to acquire cash, his or her stock portfolio will be worth $120 less than it was before the stock dividend.

Possible Value of Stock Dividends

There are limited circumstances under which a stock dividend may be more than a financial sleight-of-hand. If, at the time a stock dividend is declared, the cash dividend per share remains constant, the stockholder will receive greater total cash dividends. Assume the initial cash dividend for the XYZ Corporation will remain $1 per share even through earnings per share declined from $6.60 to $6. In this instance a stockholder going from 10 to 11 shares as the result of a stock dividend has a $1 increase in total dividends. The overall value of his total shares may then increase in response to larger dividends.

Use of Stock Dividends

Stock dividends are most frequently used by growth companies as a form of informational content in explaining the retention of funds for reinvestment purposes. This was indicated in the discussion of the life cycle of the firm in Part 69. A corporation president may state, "Instead of doing more in the way of cash dividends, we are providing a stock dividend. The funds remaining in the corporation will be used for highly profitable investment opportunities." The market reaction to such an approach may be neutral or slightly positive.

Another use of stock dividends maybe to camouflage the inability of the corporation to pay cash dividends and to cover up the ineffectiveness of management and generating cash flow. The prudent president may proclaim, "Though we are unable to pay cash dividends, we wish to reward you with a 15 percent stock dividend." Well-informed investors are likely to react very negatively. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 540-542*

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