Even if you're new to investing in the stock market, you're probably aware that stock prices will go up or down, often resulting in the "thrill of victory or the agony of defeat" for the investor. Stock prices can fluctuate due to external circumstances like famine, flood or that infamous illegal activity known as insider trading. Companies can also change the price of their stock by using legitimate means like declaring stock splits or issuing stock dividends.
Dividends and Stock Splits
A dividend is a distribution of earnings that a corporation makes to its shareholders. usually on a quarterly basis. When a dividend is issued in the form of additional stock as opposed to cash, it is known as a stock dividend. A stock split occurs when a company decides to divide its number of outstanding shares into smaller units. For example, you owned 50 shares of stock at $10 per share and a company declared a two-for-one split, you would now own 100 shares at $5 per share.
Both stock splits and stock dividends have the effect of increasing the number of outstanding shares of a company's stock. If a company had 200,000 outstanding shares and declared a 5 percent stock dividend distribution, it would then have 210,000 shares outstanding. With a stock split, the size of the share increase will be determined by the type of split, such as two-for-one, three-for-one, and so on. It should be noted that a declared stock dividend of 25 percent or larger is regarded as a stock split.
Reason for a Stock Split
A company may decide to declare a stock split because it feels that its share price is too high, which may deter potential investors or make it seem out of line when compared to competitors' stock prices. Companies may decide to pay stock dividends to their shareholders instead of cash if it wants to use cash for other purposes, like investing in future growth. This may or may not appease shareholders who have been used to receiving cash dividends on a regular basis.
Effects of a Stock Split
Neither stock splits nor stock dividends result in an increase in the shareholders' wealth. Stock splits are simply a realigning of the company's number of outstanding shares, not the stock's actual value. When a company declares a stock dividend, it must lower its stock price to balance the increase in the number of outstanding shares. In both cases, the company's overall net worth in terms of assets compared to liabilities does not change.