What’s your purpose of investing in stocks? No prizes for guessing. All stock investors aim to benefit from either capital appreciation or dividend distributions. Or, both.
No doubt strong fundamentals with high dividend yields is a must have criteria for most stock investors. But it’s important to understand how does it affect you economically before investing hastily in stocks with high dividend yields.
Dividends can take various forms. The common types are cash and stock dividends. The topic on which is better has long been debated. Many experts have shared their thoughts over the years but merely scratching the surface.
Let’s have a deep-dive on the differences between the two. And more importantly, how do they affect your wealth as a shareholder.
Many established companies typically distribute a portion of their yearly earnings to shareholders as cash dividends. Such distribution is largely dependent on the company’s dividend policy.
Generally, a company distributes excess cash as dividends after allocating a sufficient amount for working capital and future growth opportunities.
How Does it Affect Your Wealth?
Let’s assume you are holding 1,000 shares of Company XYZ and its current stock price is RM3 per share. Your total wealth is RM3,000.
Company XYZ then declares a dividend of 3 cents per share. Therefore, you are entitled to RM30 (1,000 shares * RM0.03) cash dividend.
On the ex-dividend date, the stock price reduces from RM3 to RM2.97. Now you have shares worth RM2,970 and RM30 cash in your pocket. In other words, your wealth remains unchanged at RM3,000 after receiving the dividends.
Why Stock Price is Adjusted Downwards on the ex-Dividend Date?
Unsurprisingly, many investors are puzzled as to why the stock price would reduce by the same amount of dividends distributed to shareholders.
Imagine Company XYZ has 100,000 outstanding shares. The market capitalisation is RM300,000 (100,000 * RM3 per share) before distributing any dividend.
When Company XYZ declares a dividend of 3 cents per share, it needs to pay out a total of RM3,000 cash (100,000 * RM0.03) to all shareholders.
To put it simply, the Company is poorer now with RM3,000 less in its bank account after paying dividends. As a result, the company’s market capitalisation is lower by the same amount.
Hence, the stock price after dividend is RM2.97 per share (market capitalisation of RM297,000 divided by 100,000 outstanding shares).
Alternatively, a company can also pay a dividend in the form of additional shares, also known as a stock dividend.
How Does it Affect Your Wealth?
Again, you are holding 1,000 shares of Company XYZ worth RM3 each. The company then declares a 10% stock dividend. Now the company has 110,000 outstanding shares after declaring a stock dividend. But its market capitalisation remains at RM300,000 since the company does not pay out any cash.
Each share is now worth RM2.73 after paying a stock dividend (market capitalisation of RM300,000 divided by 110,000 outstanding shares). But your shareholding is still worth RM3,000 (RM2.73 per share * 110 shares) because you own 10% more shares now.
Your ownership in Company XYZ does not change as all shareholders receive the same percentage of stock dividends. All in all, your total wealth remains the same after receiving a stock dividend.
Why Investors Prefer Investing in Dividend Stocks?
Most investors prefer to invest in stocks with high dividend yields as it reduces the volatility of their stock investments. Because they are more certain of getting back their returns in the form of cash. In contrast, there is no guarantee that the investors would benefit from future capital gains for holding stocks that never pay dividends.
Stock investors normally see it as a good sign when a company distributes dividends consistently. It signals that the company has sustainable earnings to pay out dividends. A company that increases its dividend distribution over time also indicates the growing profitability of its business.
Many companies refrain from paying excessive dividends which may possibly cause a reversal in the future. More often than not, the stock price reacts badly when there’s a reduction in dividends. Because it casts doubt on the company’s fundamentals as well as its sustainability in the future.
Why do Companies Pay Stock Dividends?
There are various reasons why some companies prefer to pay stock dividends than cash dividends.
A stock dividend increases the company’s outstanding shares, thus improving its liquidity as well. Some companies also pay stock dividends to decrease their stock price to maintain it at the optimal trading range to attract more investors.
As stock investors do not have the expectation of receiving regular stock dividends, the companies have a lower risk of reducing their cash dividends in the future during bad times.
Besides, the companies can also take advantage of excess cash to capitalise on profitable investment opportunities.
Though a stock dividend has no effect on shareholder’s wealth, the stock market generally reacts positively to a stock dividend announcement.
The Impact on Company’s Financial Ratios
Cash and stock dividends also affect a company’s financial ratios differently. A cash dividend decreases the company’s liquidity ratios (i.e. current ratio) as the company has less cash after making a dividend payment. It also decreases the company’s equity value, thus increasing the leverage ratios (i.e. debt-to-equity ratio).
In contrast to cash dividends, a stock dividend does not affect the company’s liquidity and leverage ratios. However, a stock dividend decreases the company’s earnings per share (net income/outstanding shares) as there are more outstanding shares following a stock dividend.
In summary, both cash and stock dividends have the same effect on the shareholder’s value. Does that mean that you should be indifferent towards receiving a stock or cash dividend?
It all boils down to one question. What’s your investment objective?
Are you investing in stocks to build a stable stream of passive income and cash flows?
Or, are you focusing on long-term capital appreciation? Of course, nothing stops you from realising a portion of your shareholding when you need money anytime.
Before investing in any particular stock with high dividend yields, it’s rather important to evaluate the stock’s fundamentals and its growth prospect. Dividend coverage ratio (net income/dividends) is one of the traditional metrics used to assess the company’s sustainability to maintain its current dividend pay out. Real Estate Investment Trust (REIT) has gained traction over the years due to its high dividend yield. Read: Real Estate Investment Trust (REIT) – Introduction for further understanding.