Ownership comes with its perks, and common stockholders have several of them. Stockholders do not have the right to vote for dividends, but do have the right to receive their pro-rata share. Pro-rata relates to the number of shares owned. For example, if a stockholder owns 10% of the outstanding shares, they receive 10% of dividends paid. Only the issuer’s board of directors (BOD) approves dividend payouts. We’ll discuss the BODs in further detail in the next section.
Common stocks may pay dividends in three forms:
Companies sell their products and services in return for revenue. Once revenue is received, it goes to offset the costs of business expenses. These include the cost of goods sold, operational expenses, interest on outstanding loans, and taxes. If a company has leftover profits after paying its business costs, it has profits (earnings).
Profits are utilized in one of three ways. Companies can retain the profit (also known as retained earnings), pay the profit to their shareholders in the form of a cash dividend, or do a little of both. Companies attempting to expand significantly (known as growth companies) generally do not pay cash dividends. To grow their business, they’ll need to invest their profits into their business. This could include purchasing new properties, obtaining equipment or vehicles, or hiring new employees, which are standard practices for start-ups and smaller companies.
Larger, well-established companies beyond their initial growth phase are more likely to pay cash dividends to their shareholders. For example, McDonald’s started paying dividends in 1976, nearly ten years after it began to expand its business globally. By 1976, McDonald’s was a global brand making significant earnings and started sharing its profits with its investors.
Cash dividends are paid out on a per share basis (for instance, $1 per share). Companies that pay cash dividends on common stock typically make payments quarterly, although this is not required (for example, some prominent companies pay annual cash dividends).
A stock dividend is a payment of extra shares to stockholders. Although investors receive more shares of stock, this type of dividend is a wash. Stock dividends are simply a “re-shuffling” of numbers to manipulate a stock price. If a company pays a stock dividend of 25%, each investor will end up with 25% more shares. However, each share will fall proportionally in price. Ultimately, a stock dividend does not increase the overall value of a stock position.
As an analogy, imagine you have an apple pie, which we’ll consider as one unit of pie. If you were to cut that apple pie in half, you technically have two units of pie. While you have more pie units, you don’t have more overall pie. Did you track that? If so, a stock dividend is similar.
Here’s an example of a stock dividend question:
An investor owns 100 shares of stock at $20/share. The investor receives a 25% stock dividend. What changes?
Let’s go through the math. The first step is to find the “stock dividend factor.”
To find the “stock dividend factor”, add the stock dividend percent (in decimal form) to 1.
To find the new number of shares, multiply the original number of shares by the “stock dividend factor.”
To find the price per share adjustment, divide the original price per share by the “stock dividend factor.”
Put it all together and compare the before and after to confirm:
| Status | Position | Overall value |
|---|---|---|
| Pre-dividend | 100 shares @ $20 | $2,000 |
| Post-dividend | 125 shares @ $16 | $2,000 |
As you can see, the investor ends with the same overall value they started with ($2,000). Use this comparison to confirm your calculation was correct.
Let’s see if you can navigate a stock dividend scenario successfully on your own.
An investor owns 300 shares of JPM stock @ $115. They receive a 15% stock dividend. What changes?
Step 1: stock dividend factor
Step 2: shares adjustment
Step 3: price adjustment
Step 4: confirm that the overall value is the same
| Status | Position | Overall value |
|---|---|---|
| Pre-dividend | 300 shares @ $115 | $34,500 |
| Post-dividend | 345 shares @ $100 | $34,500 |
Companies can make dividend payments from inventory or another company’s stock. For example, Amazon could issue one Kindle per share of stock owned by investors. This type of dividend is not commonly issued, mainly because it’s a taxable event regardless of the investor’s desire for Kindles. How would you feel if you owned 10 shares of Amazon, received 10 Kindles that you didn’t need or want, and got a tax bill for each? Cash and stock go much further, which is why they are much more popular.
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