Pro-rata share of dividends

Ownership comes with perks, and common stockholders have several of them. Stockholders don’t vote on whether dividends are paid, but they do have the right to receive their pro-rata share of any dividend that is declared. Pro-rata means “in proportion to shares owned.” For example, if you own 10% of the outstanding shares, you receive 10% of any dividends paid.

Only the issuer’s board of directors (BOD) can approve dividend payouts. We’ll cover the BOD in more detail in the next section.

Common stocks may pay dividends in three forms:

• Cash
• Stock
• Product

Cash dividends

Companies sell products and services to earn revenue. That revenue is used to pay business expenses, such as:

• Cost of goods sold
• Operating expenses
• Interest on outstanding loans
• Taxes

If money is left after covering these costs, the company has profits (also called earnings).

Companies generally use profits in one of three ways:

• Keep the profits in the business (called retained earnings)
• Pay some profits to shareholders as a cash dividend
• Do a combination of both

Companies trying to expand quickly (often called growth companies) usually don’t pay cash dividends. They typically reinvest profits back into the business - for example, by buying property, purchasing equipment or vehicles, or hiring employees. This is common for start-ups and smaller companies.

Larger, well-established companies that are past their early growth phase are more likely to pay cash dividends. For example, McDonald’s started paying dividends in 1976, nearly ten years after it began expanding globally. By that point, McDonald’s was generating significant earnings and began sharing profits with investors.

Cash dividends are paid on a per-share basis (for example, $1 per share). Companies that pay cash dividends on common stock typically pay quarterly, although this isn’t required (some companies pay annually).

Stock dividends

A stock dividend is a dividend paid in additional shares. Even though you end up with more shares, a stock dividend is essentially a wash: the share price adjusts downward in proportion to the increase in shares.

For example, if a company pays a 25% stock dividend, each investor ends up with 25% more shares. However, each share falls proportionally in price. As a result, a stock dividend does not increase the overall value of the position.

A helpful analogy is slicing a pie. If you cut one pie into more slices, you have more pieces - but you don’t have more pie. A stock dividend works the same way: more shares, but the same total value.

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 work 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.

$\text{SD factor}=\text{SD (decimal form) + 1}$

$\text{SD factor}=\text{0.25 + 1}$

$\text{SD factor}=\text{1.25}$

To find the new number of shares, multiply the original number of shares by the “stock dividend factor.”

$\text{New shares}=\text{old shares x SD factor}$

$\text{New shares}=\text{100 x 1.25}$

$\text{New shares}=\text{125}$

To find the price per share adjustment, divide the original price per share by the “stock dividend factor.”

$\text{New price}=\frac{\text{old price}}{\text{SD factor}}$

$\text{New price}=\frac{\text{\$20}}{\text{1.25}}$

$\text{New price}=\$16$

Put it all together and compare the before and after to confirm:

As you can see, the investor ends with the same overall value they started with ($2,000). This before-and-after comparison is a good way to confirm your calculation.

Now try a stock dividend scenario on your own.

An investor owns 300 shares of JPM stock @ $115. They receive a 15% stock dividend. What changes?

Product dividends

Companies can also pay dividends using inventory or another company’s stock. For example, Amazon could issue one Kindle per share owned by investors.

This type of dividend isn’t common, mainly because it’s a taxable event whether or not the investor wants the product. For example, if you owned 10 shares of Amazon, you could receive 10 Kindles you don’t need and still owe taxes on the value received. Cash and stock dividends are usually more practical, which is why they’re much more common.