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What Is A Stock Dividend And How Does It Work?
A stock dividend is a dividend payment to shareholders made in shares instead of cash. For example, if you own 50 shares of a stock and the company issues a stock dividend of 10%, you will receive five (5) additional shares.
Effect On Market Capitalization: While a stock dividend increases the number of shares outstanding for a firm, it doesn't affect the market capitalization or the shareholder wealth. As with a cash dividend, the stock price tends to decrease when the dividend is paid.
Stock Dividend Taxation: Stock dividends are not taxed until the recipient sells the shares received. However, if there has a cash-dividend option, the distribution is generally taxed even if the recipient doesn't sell the shares received.
When And Why Do Companies Issue A Stock Dividend?
There are several reasons why companies choose to issue stock dividends, but the most common one is that they want to reward shareholders while preserving cash.
Let's take the recent coronavirus crisis as an example. The crisis has been difficult for chain restaurant companies. Many have had to close restaurants completely despite paying fixed cash costs like rent. With many countries still in lockdown and an unclear timeline for reopening, businesses need to be very prudent with their cash balance.
This is what happened to the world's largest independent McDonald's franchisee: Arcos Dorados (NYSE:ARCO). With nearly 2,300 restaurants, the company has the exclusive right to own, operate, and grant franchises of McDonald's restaurants in 20 Latin American and Caribbean countries and territories.
Due to the COVID-19 pandemic, the firm has canceled the two planned cash dividend payments for 2020. Instead, it plans to distribute a stock dividend of one (1) share for every seventy-five (75) shares held by its shareholders.
Stock Dividend Advantages
As discussed, stock dividends are beneficial for both businesses and investors since they provide greater flexibility while enabling companies to reward shareholders even in challenging circumstances. Distributing a stock dividend offers several advantages, including:
- Favorable Taxation: Stock dividends are generally not taxed until the recipient sells the shares received. For this reason, receiving stock dividends is much better than reinvesting cash dividends after paying taxes.
- Saving Cash: Stock dividends enable companies to reward shareholders even in unexpected crises, such as the coronavirus pandemic. By issuing a stock dividend, firms can save cash and extend the runway.
Stock Dividend Disadvantages
Stock dividends have the following disadvantages:
- Market Reaction: Under challenging circumstances, companies can distribute a stock dividend to save cash. The market may perceive a stock dividend as a warning sign that the company is facing financial troubles, and react unfavorably.
- Passive Income Investors: If you are an investor seeking passive income, a stock dividend may not fit your needs. Passive income investors are looking for, well, passive income! They want to receive the cash directly in their bank account without having to sell shares and reduce their ownership percentage.