On occasion, firms distribute additional shares of stock to shareholders in proportion to the number of shares presently owned. If a firm declares a one percent stock dividend, for example, this means that existing shareholders will receive additional shares equal to one percent of their present holdings. In this case, a shareholder with 100 shares would receive an additional share (1% * 100 shares) as a stock dividend.
Stock dividends reduce retained earnings in an amount equal to the value of the stock that is distributed. As an example, assume that the Flotsam Company has 10 million common shares issued and outstanding and declares a two percent stock dividend when the market price of its stock is $45 per share. The firm will distribute an additional 200,000 shares (2% * 10 million shares = 200,000 shares), and the total value of the dividend is $9 million ($45 * 200,000 shares = $9 million). Retained earnings will decrease, and paid-in capital will increase, by $9 million. The number of shares outstanding will also increase by two percent.
Notice that this transaction does not affect the firm’s assets and liabilities, and therefore does not affect total shareholders’ equity. The composition of shareholders’ equity is affected, however. The transaction decreases retained earnings and creates an off-setting increase in paid-in capital.
As a stockholder of 100 shares of Flotsam Company, would you be better off as a result of the stock dividend? Although it is true that you have received two additional shares of stock, your proportionate interest in Flotsam remains unchanged. Moreover, because the company’s assets and liabilities are unchanged, the stock dividend has no direct effect on Flotsam’s operating capability. In fact, the market price of each share of stock could decline just enough to leave the total value of your investment unchanged (100 shares * old price = 102 shares * new price).
Surprisingly, stock dividends do appear to benefit existing shareholders. The market price per share of existing shares usually does not decline sufficiently to offset the effect of issuing additional shares. Some analysts suggest that this otherwise puzzling result may be due to the use of stock dividends as a “signal to the market”by managers that the firm expects higher profits and cash flows in the future. Managers may be reluctant to make public forecasts about future earnings increases, however, and may instead prefer to communicate their favorable expectations by less direct actions such as stock dividends.