Following are the various forms of dividends:
* Cash dividends * Stock dividends and stock splits * Property dividends * Special distributions, extra dividends, spin-offs and split-offs
Table 2-1. Dividends: How Important Are They?
The average dividend yield on the 500 stocks in the Standard & Poor’s (S&P) Index was 1.99 percent in May 2006, and the dividend payout ratio was 28 percent. In other words, company managers retained 72 percent of company profits for their own preferred uses.
So why are dividends important if companies pay such a small percentage in dividends? The importance of dividends lies in their tax benefits.
In 2003, federal tax rates on qualified dividends were lowered to a maximum rate of 15 percent if held for the required length of time. This lowered tax rate makes investing in dividend-paying stocks more advantageous from a tax point of view than many taxable bonds, where interest is taxed at the taxpayer’s marginal rate, which can be as high as 35 percent.
A cash dividend is a dividend paid in cash. To be able to pay cash dividends, companies need to have not only sufficient earnings but also sufficient cash. Even if a company shows a large amount of retained earnings on its balance sheet, it may not be enough to ensure cash dividends. The amount of cash that a company has is independent of retained earnings. Cash-poor companies still can be profitable.
Most American companies pay regular cash dividends quarterly; some pay dividends semiannually or annually. Johnson & Johnson, the pharmaceutical company, pays quarterly dividends, and McDonald’s pays an annual dividend. A company might declare extra dividends in addition to regular dividends. An extra dividend is an additional, nonrecurring dividend paid over and above the regular dividends by the company. Microsoft Corporation paid an extra dividend of $2 per share over and above its regular dividend to shareholders of record holding the stock on November 15, 2004. Rather than battle to maintain a higher amount of regular dividends, companies with fluctuating earnings pay out additional dividends when their earnings warrant it. Whenever times were good for the automobile industry, for example, General Motors declared extra dividends.
Some companies choose to conserve their cash by paying stock dividends, a dividend paid in stock. The companies then recapitalize their earnings and issue new shares, which do not affect its assets and liabilities. Table 2–2 shows an example of a company’s balance sheet before and after a 10 percent stock dividend.
Effects of a Stock Dividend on a Company’s Balance Sheet
In this table, the “Total equity” section of the balance sheet is the same before and after the stock dividend ($200,000). The amounts that are transferred to the different accounts in the equity section depend on the market value of the common stock and the number of new shares issued through the stock dividend. Amounts from retained earnings are transferred to the common stock and additional paid-in capital accounts. In this example there are 10,000 additional shares that have a market price of $5 per share. The “Retained earnings” account is debited (deducted) for $50,000 (market price of $5*10,000 shares), and $10,000 (10,000 shares * $1 par value) is added to the common stock account. The other $40,000 ($4 premium over par value * 10,000 shares) is added to the additional paid-in capital account.
Receiving a stock dividend does not increase shareholders’ wealth. Shareholders who receive a stock dividend receive more shares of that company’s stock, but because the company’s assets and liabilities remain the same, the price of the stock must decline to account for the dilution. For shareholders, this situation resembles a slice of cake. You can divide the slice into two, three, or four pieces, and no matter how many ways you slice it, its overall size remains the same. After a stock dividend, shareholders receive more shares, but their proportionate ownership interest in the company remains the same, and the market price declines proportionately.
Stock dividends usually are expressed as a percentage of the number of shares outstanding. For example, if a company announces a 10 percent stock dividend and has 1 million shares outstanding, the total shares outstanding are increased to 1.1 million shares after the stock dividend is issued.
A stock split is a proportionate increase in the number of outstanding shares that does not affect the issuing company’s assets, liabilities, or earnings. A stock split resembles a stock dividend in that an increase occurs in the number of shares issued on a proportionate basis, whereas the assets, liabilities, equity, and earnings remain the same. The only difference between a stock split and a stock dividend is technical.
From an accounting point of view, a stock dividend of greater than 25 percent is recorded as a stock split. A 100 percent stock dividend is the same as a two-for-one stock split. Acompany might split its stock because the price is too high, and with a lower price the company’s stock becomes more marketable.
The following example illustrates what happens when a company declares a two-for-one stock split. If at the time of the split the company has 1 million shares outstanding and the price of the stock is $50, after the split the company will have 2 million shares outstanding, and the stock will trade at $25 per share. Someone who owns 100 shares before the split (with a value of $50 per share) would own 200 shares after the split with a value of approximately $25 per share (50 / 2). On January 16, 2003, Microsoft Corporation announced a two-for-one stock split that took effect on February 18, 2003. Before the split, Microsoft closed at $48.30 per share. On the morning of the split, it opened at $24.15 per share. An investor with 100 shares before the split would have had 200 shares after the split.
Occasionally, companies announce reverse splits, which reduce the number of shares and increase the share price. A reverse split is a proportionate reduction in the number of shares outstanding without affecting the company’s assets or earnings. When a company’s stock has fallen in price, a reverse split raises the price of the stock to a respectable level. Another reason for raising the share price is to meet the minimum listing requirements of the exchanges and the Nasdaq market. For example, a stock trading in the $1 range would trade at $10 with a 1-for-10 reverse split. The number of shares outstanding would be reduced by 10 times
after the split. On November 19, 2002, AT&T had a reverse stock split of one-for-five shares. See Table 2–3 for a discussion of whether there are any advantages to stock dividends and stock splits.
Are there Advantages to Stock Dividends and Stock Splits?
If shareholder wealth is not increased through stock dividends and stock splits, why do companies go to the trouble and expense of issuing them?
The first advantage for the issuing company is a conservation of cash. By substituting stock dividends for cash dividends, a company can conserve its cash or use it for other investment opportunities. If the company successfully invests its retained earnings in business ventures, the stock price is bid up, benefiting shareholders. Consequently, shareholders are better off receiving stock dividends, but there are costs associated with the issue of stock dividends. Shareholders pay the cost of issuing new shares, the transfer fees, and the costs of revising the company’s record of shareholders.
Advocates of stock dividends and stock splits believe that a stock price never falls in exact proportion to the increase in shares. For example, in a two-for-one stock split, the stock price might fall less than 50 percent, which means that shareholders are left with a higher total value. This conclusion has not been verified by most academic studies. When the price of the stock is reduced because of the split, the stock might become more attractive to potential investors because of its lower price. The increased marketability of the stock might push up the price if the company continues to do well financially; stockholders benefit in the long run by owning more shares of a company whose stock price continues to increase.
Stock dividends and stock splits do not increase stockholder wealth from the point of view of the balance sheet. Cash dividends, however, directly increase a shareholder’s monetary wealth and reduce the company’s cash and reinvestment dollars.
A property dividend is a dividend paid in a form other than cash or the company’s own stock. Aproperty dividend is generally taxable at its fair market value. For example, when a corporation spins off a subsidiary, shareholders might receive assets or shares of that subsidiary. Distributing the stocks or assets of the subsidiary (rather than cash) allows shareholders to benefit directly from the market value of the dividends received.
Companies sometimes make special distributions in various forms, such as extra dividends, spin-offs, and split-offs.
Extra Dividends Companies might want to distribute an extra dividend to their shareholders on a one-time or infrequent basis. A company might have had a particularly good quarter financially, or other reasons for this distribution might exist. The company might use a special distribution rather than increase its regular dividends because the distribution is a one-time occurrence. Companies would not want to increase their dividend rates if they could not continue paying those increased rates in the future.
Spin-Offs A spin-off is the distribution of shares of a subsidiary company to shareholders. Some companies allocate proportionately to their shareholders some or all of their shares of a subsidiary company as a spin-off. For example, on August 9, 2005, IAC/InterActive Corporation (ticker symbol IACI) spun off Expedia Corporation (ticker symbol EXPE) to shareholders to allow it to focus on its business. Prior to the spin-off (August 8, 2005), InterActive Corporation had a one-for-two reverse stock split. For every two shares of InterActive Corporation common stock owned as of August 8, 2005, shareholders received one share of InterActive Corporation and one share of Expedia common stock. Shareholders have the option of keeping or selling the additional shares they receive. Companies spin off unrelated or underperforming businesses to shareholders so that they can concentrate on their own business. In many cases the shares of spin-off companies outperform their parent companies because the new stand-alone companies can expand in directions where they are no longer hindered by their parent companies.
Split-Offs A split-off is the exchange of a parent company’s stock for a pro-rata share of the stock of a subsidiary company. Splitoffs, which differs from spin-offs, do not occur frequently. In a splitoff, shareholders are offered the choice of keeping the shares they own in the existing company or exchanging them for shares in the split-off company. For example, on August 10, 2001, AT&T completed a split-off of Liberty Media Corporation. AT&T redeemed each outstanding share of its class A and class B Liberty Media tracking stock for one share of series A and series B common stock, respectively, from Liberty Media. In a split-off, an exchange of shares takes place, whereas in a spin-off, shareholders receive additional shares in another company.
Although shareholders obviously benefit from receiving dividends, they also benefit when earnings are not paid out but instead are reinvested in the company. This technique increases the value of the company and hence the value of its stock.
Table 2–4 discusses dividend reinvestment plans for investors wishing to reinvest their dividends directly in the stock of the companies they already own.
What Are DRIPS?
A dividend reinvestment plan (DRIP) allows shareholders to reinvest their dividends in additional stock rather than receiving them in cash. These plans are offered directly by companies or through agents acting on behalf of the corporation. In the former case, a company issues new shares in lieu of cash dividends. You also have the option of purchasing additional shares from the company. The advantage is that you pay no brokerage fees, although some companies charge fees for this service.
The other type of plan is offered by agents, such as banks, that collect the dividends and offer additional shares to shareholders who sign up for the plan. The bank pools the cash from dividends and purchases the stock in the secondary market. Investors are assessed fees, which cover the brokerage commissions and the fee charged by the bank.
The advantage of DRIPs to shareholders is that they act as a forced savings plan; dividends are reinvested automatically to accumulate more shares. This method is particularly good for investors who are not disciplined savers.
A disadvantage of DRIPs is that shareholders need to keep, for tax purposes, accurate records of the additional shares purchased. When additional shares are sold, the purchase price is used to determine whether there is a capital gain or loss. These dividends are considered taxable income whether they are received in cash or automatically reinvested in additional shares. Another disadvantage of DRIPs is that the fees charged to participate in this program can be high.