The Ultimate Dividend

Much is talked about dividend investing. But few know of one particularly type of dividend that I think is very powerful if employed appropriately and honestly (that is, if it's not abused by unscrupulous managers): stock dividend.


Because stock dividend:
  1. Lets the investor control how much in taxes he/she wants pay.
  2. Lets the investor decide whether to reinvest in the company or cash out and buy another investment.
  3. Is tax free.
Here's how it works. Suppose company A has X in earnings. It can choose to issue a fraction of X as dividends and retain the rest. If dividends are paid, say Y% of X, investors face an automatic dividend tax hit and then need to make a decision whether to buy something else, reinvest the proceeds in the company or let it sit somewhere, such as in a money market account.

But company A could elect to issue a stock dividend instead, in the same amount as before (Y%). The stock price should go down proportionally, like what happens when companies pay out a cash dividend. But then the investor has extra shares, that make up the same total he had before. The only difference is that he now has a few extra shares, which he can keep or sell for cash as before -- the difference is having the choice.

If stock dividend is more flexible than cash dividends but otherwise equal, why don't companies choose to do it all the time?

I think it has to do with the fact that many investors don't understand it well and also due to the danger of companies being perceived as being in a weak financial situation.

As it happens, companies typically issue stock dividends when they need to conserve cash. Two recent examples are Sunstone Hotels (SHO) and Lloyds Bank (LYG). Sunstone not only paid out in stock, but it raised its dividend -- using money that it did not have. Its payout ratio is a whopping 216%. So, in this case, the stock dividend is nothing more than a stock split. It does nothing for the shareholders.

Similarly, Lloyds paid out 339% of its "earnings" in stock, also using money it did not have.

These are examples of when not to pay a dividend -- in cash or stock.

Now, going back to why stock dividends are useful if employed properly by honest companies.

Let's go back to our company A above. It has X in retained earnings, it could issue 2X or 3X (or any number) in shares and declare as large a "dividend" as it wants, like SHO and LYG. But let's say they're responsible folks and won't pay out more than say 0.5X. If the company pays out cash, the share price is automatically reduced by 0.5X divided by the number of outstanding shares -- to reflect that X dollars are now no longer part of the company's assets.

On the other hand, if company A chooses to pay out in stock, the share price will also decrease by an amount proportional to the new shares issues, which is exactly 0.5X divided by the share count. But now investors have 0.5X in extra stock certificates. They can elect to maintain their claim on the entire share they had, or sell the extra shares for income, just as if the company had paid out in cash. Either way, the result is the same.

Here's an illustration:

With stock dividends, the default behavior is to reinvest the money in the company (without incurring transaction costs nor taxes) while in the cash dividend case, the investor had no such choice -- he had to pay taxes and then take an action to deploy his new cash.

I think all companies should consider using stock dividends more often. All else being the same, investors should be given more control over their tax and reinvestment situations.

However, to avoid the situation where share counts increase but no cash ever exchanges hands, I'd like to see a hybrid approach: companies should pay out a quarterly cash dividend, and yearly they should issue a special stock dividend with the unpaid part of their earnings -- like they do with bonuses for their employees. This special stock dividend would fluctuate in value over time, to reflect the company's ups and downs as it goes through good and bad times.


  1. I very much disagree.
    The cash dividend receiving investor does have a choice. Its called a DRIP.
    You can decide if you want your dividend paid in cash or with extra shares so in this case you have a choice. If the company pays in stock you have to take that and have no choice.
    If the company offers stock and you want cash you then have to sell your shares and pay a broker commission fee to do so.

    I am pretty sure you still have to pay taxes on any dividends even if its in the form of stock. This last point I am not 100% sure about so could be wrong on that one.

  2. Actually, DRIP involves taxes too (see link below). And note that there's typically a commission for investing in a DRIP too. See: http://www.fairmark.com/capgain/basis/drip.htm

    Stock dividends, on the other hand, are usually tax-free, just like a stock split. See this link: http://www.wwwebtax.com/income/dividends.htm

    If you sell the dividend stock, you'll pay taxes though, but they could be at the same rate as qualified dividends (currently 15%) if it's a long-term holding.