John D. Rockefeller once said, "Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
Just like Rockefeller, do you enjoy the idea of investing for dividend returns?
When you invest with dividends in mind, you expect to receive returns for your dividends. However, some companies do not pay out returns in the form of cash — they pay stock dividends instead.
In this article, we'll go over the exact definition of dividend stocks and give some dividend stocks examples. We'll also go through several pros and cons of owning stock dividends. By the time you're done reading, you may be closer to understanding whether investing in dividend stocks makes sense for your portfolio and your future goals.
What is a Stock Dividend?
When publicly traded companies and private companies make money, they often return a portion of their earnings to investors in the form of dividends. A stock dividend is a reward paid to you, the shareholder, in additional shares instead of cash.
Sometimes companies offer you a choice between cash or additional company stock. This is called a scrip dividend program. A stock dividend only gives out additional shares, without giving you a choice between cash or shares of stock.
Why do companies decide to issue stock dividends instead of paying shareholders cash? They may choose to do so in order to increase their shares of stock outstanding, reduce the market price per share, transfer some of the company's retained earnings to paid-in capital and minimize cash distributions to shareholders. Some companies with little cash and equivalents may use stock dividends to reward shareholders, but keep in mind that that reason alone could be the reason you may want to put the brakes on investing in a company from the get-go.
How Do Stock Dividends Work?
How do companies determine how to pay out stock dividends? Let's walk through four important dates to know: the declaration date, record date, ex-dividend date and payment date. These dates indicate exactly how a company will outline its dividend and how you will receive it:
- Declaration date: The declaration date, also called the announcement date, refers to the date that a company you’ve invested in announces its dividend payment plans.
- Record date: If you are an investor who is on record as a shareholder on the record date, you will receive a dividend payment from the company in which you've invested. The company chooses the record date.
- Ex-dividend date: You must have already purchased shares of the company in question by the ex-dividend date. If you haven't purchased shares of stock by this date you will not receive the next dividend payment. In addition, if you're thinking about selling your stock but still want to claim the dividend, you need to hold onto your shares of stock until the ex-dividend date. The ex-dividend date is typically one business day prior to the record date. The company does not choose the ex-dividend date — the stock exchange’s rules determine the ex-dividend date.
- Payment date: On this date, you’ll receive your stock dividends from the company in which you've purchased shares.
Unquestionably, the ex-dividend date is the most important of these dates because the company knows whether you qualify to receive the dividend.
Dividend Stocks Examples
Let's take a look at a few examples of how dividend stocks might work.
Let's say Jennifer holds 1,000 shares of XYZ Company. The board of directors of ABC Company announced a 10% stock dividend on the declaration date. This means that Jennifer will own 1,100 shares of the company as of the payment date.
In another example, let's say a company announces a 15% stock dividend on the declaration date with a record date of June 15. In this case, the ex-dividend date would be June 14, one business day before the record date. Emily rushes to buy shares before the ex-dividend date and purchase 1,500 shares of stock before June 14. Emily qualifies to receive company stock, and on the payment date, August 15, Emily ends up with a total of 1,725 shares of stock.
Pros and Cons of Receiving Stock Dividends
What is the benefit to receiving stock dividends over cash in your pocket? Why might you want a stock dividend instead of cash from a company? Let's go over the pros and cons.
Pros of Stock Dividends
What are the benefits of taking stock dividends?
- Maintain a cash position: Investing in a company that doesn't have a lot of cash floating around may choose to pay a stock dividend instead of pay out cash. A cash dividend allows a company to keep its current cash position instead of giving it to investors, which can be good for companies that need a favorable cash position.
- No taxes: You don't have to pay taxes on stock dividends. Cash dividends, on the other hand, get taxed at either the lower long-term capital gains tax rate or the higher nonqualified, or ordinary, dividend tax rate. Nonqualified dividends are taxed at the same rates as an individual's regular income. Qualified dividends are tax-free for individuals in the 10%, 12%, and 22% tax brackets, while the 22%, 24%, 32%, and 35% tax brackets receive a 15% tax rate. Those who fall in the 35% or 37% tax bracket must pay a 20% rate.
- Collect more shares: Naturally, one of the benefits to dividend stocks is that you continue to garner more shares and could benefit you if you save up until retirement to sell your shares. Over time, you'll benefit from compounding, which means you could be in line for a big payout.
Cons of Stock Dividends
What are the cons of stock dividends?
- No cash: Obviously, the biggest downside is that you won't receive cash in your pocket on the payment date. This might be a problem if you're counting on dividend income to support you on a month-to-month basis.
- Market participants may get the wrong message: Other market participants may see a stock dividend as a sign that something is wrong with the company or that the company intends to use its cash to invest in risky projects. In the absence of a cash dividend, investors may believe they should dump the stock, which could send share prices tumbling.
- Negative impact on share prices: If a company issues a cash dividend, shareholders will see a decrease in the price of shares. In other words, they see an economic value transfer. For example, let's say that a company announces a 4% cash dividend. After the ex-dividend date, the share price drops 4%, which can dilute earnings. Share prices often end up seeing a negative impact simply due to a dividend announcement.
It's a good idea to review the pros and cons so you know whether dividend investing is for you. You may also want to dig into some other metrics so you know whether you're investing in a solid company, particularly when you could be working with a company that may suffer from liquidity issues. Check on a few company highlights including the dividend yield, stock price and fundamentals.
The dividend yield shows you how much a company pays out in dividends each year relative to its stock price. You can also do research on the company's past dividend growth rate by determining how long the company has offered consecutive dividend increases. In the case of the Dividend Kings and Dividend Aristocrats, these companies have raised their dividend yield over 50 and 25 years, respectively.
Finally, understand the cost of each share of stock and dig deep — look at the company's business model. Look into financial statements, prospectuses, long-term profitability, balance sheets and debt (by examining the company’s debt-to-equity ratio), sector trends and more.
Should You Accept Dividend Stocks Instead of Cash?
So, to sum up, when companies want to reward investors, they return a portion of their earnings to investors through dividends. Instead of cash in your pocket, you receive shares of stock.
As with most things, there are pros and cons to investing in a company that offers dividend stocks in lieu of cash. The benefits of investing include maintaining a cash position and not paying taxes.
The downsides include the fact that you're not collecting cash in your pocket. The market may also get the message that something is wrong with the company due to a negative impact on share prices.
As long as a company continues to do well, accepting more dividends could benefit you in the long run, possibly more than the cash would. However, in the case of companies that struggle with liquidity, you may want to invest your money somewhere else. Fortunately, you also have a choice of what you want to do with the extra shares that you receive. You can keep the extra shares or you can sell them in order to create your own version of a dividend. There is more than one way to make a profit!