Considering the fact that the equity shareholders are the owners of a company, they enjoy a claim on the profits that the said company generates. These profits that are generated by a company are periodically distributed to the shareholders by way of dividends. Since these dividends act as a source of steady income for equity shareholders, many investors adopt a dividend investing strategy.
However, a company need not always distribute its profits by way of cash dividends. In fact, there’s also another way in which a company can distribute its profits to its equity shareholders – through stock dividends. Knowing the difference between cash dividend and stock dividend is essential if you’re planning to adopt a dividend investing strategy. Here’s an in depth overview of cash dividend vs stock dividend.
What is a cash dividend?
When investors and other financial experts use the word ‘dividend’, they’re usually referring to cash dividend. When a profitable company distributes dividend to its shareholders by way of cash, it is known as cash dividend. Here’s an example that can help you better understand the concept.
Assume that there’s a company ABC Limited. The company has issued around 1,00,000 equity shares. The net profit earned by the company for the financial year 2019 – 2020 is around Rs. 20 lakhs. The company decides to distribute the entire share of profits earned by it to its shareholders. And so, the dividend that the company has to distribute by way of cash for every equity share issued by the entity can be calculated as follows.
Dividend per equity share = Net profit ÷ total number of issued equity shares
Dividend per equity share = Rs. 20,00,000 ÷ 1,00,000 = Rs. 20/-
Since the company has decided to distribute its profits as cash, this instance is a classic example of cash dividend.
What is a stock dividend?
Now that you’re aware of what cash dividend is, let’s move on and take a look at the concept of stock dividend.
When a company, whether profitable or not, decides to distribute its own stocks to its equity shareholders in exchange for their investment in the company, it is said to have distributed stock dividends. Here’s an example of stock dividends that can help you better understand the concept.
Let’s take up the same company ABC Limited. Here again, the company has issued around 1,00,000 equity shares. The company decides to reward its equity shareholders with a dividend. But the company’s net profit is unfortunately not enough to cover the payment of cash dividends to all of its equity shareholders. And so, the company decides to allot its own unissued equity shares to its equity shareholders. The company decides to distribute a 10% stock dividend to its equity shareholders.
This would effectively mean that the company would have to allot an additional 10,000 shares (1,00,000 equity shares x 10%) to its equity shareholders. So, for every 10 equity shares held by a shareholder, he would get 1 equity share of the company as dividend payment completely free of cost. Once the stocks are allotted, the investors can either choose to retain the share or sell it in the stock market at the current trading price. Such an instance is a classic example of a stock dividend.
Difference between cash dividend and stock dividend
Since you’re now aware of what the concepts of cash dividend vs stock dividend entails, let’s take a look at the difference between cash and stock dividend. The most important and primary differences between these two have been elaborated below.
Involvement of cash reserves:
This is arguably the most important difference between cash and stock dividend. The payment of cash dividends by a company to its equity shareholders involves tapping into the cash reserves of the said entity. With cash dividends, the profits of the company are paid out instead of being reinvested in its business.
On the other hand, with stock dividends, a company doesn’t have to tap into its cash reserves or profits since it is only issuing its own stock to its equity shareholders.
Repercussions for the company:
Since a company taps into its cash reserves for issuing cash dividends to its equity shareholders, such a move ends up depleting its funds. This can at times become disadvantageous for a company since it cannot tap into its cash reserves for emergency purposes.
On the contrary, a company’s cash reserves stay intact in the event of a stock dividend distribution. But since the company is essentially issuing more shares to its existing shareholders, it can bring about a dilution in the ownership control of the entity.
Repercussions for the shareholder:
Another major difference between cash and stock dividend lies in the way in which the shareholder gets affected. If an equity shareholder of a company receives a cash dividend, it is considered to be an income and therefore the shareholder would have to disclose the income and pay tax on it.
But with a stock dividend, since the equity shareholder only receives more equity shares, it is not construed as an income and therefore not liable for taxation. That said, the shareholder would have to pay tax if he sells his shareholding out in the open market since that would construe as revenue.
As you can see from the above three points, these are the primary differences between cash dividend and stock dividend. If you’re an investor looking for a consistent and steady source of income, then cash dividend might be the right way for you since it is far less riskier.
On the contrary, if you’re an investor with a penchant for risk and who is looking for capital and price appreciation, investing in a company that frequently pays stock dividends may be the right way to go. But ultimately, when it comes to cash dividend vs stock dividend, there’s no clear winner since it all depends on the preferences of the individual investor.