Stock Dividends and Stock Splits

Stock dividends and stock splits are related to the firm’s cash dividend policy. The rationale for stock dividends and splits can best be explained through an example. We will use Porter Electronic Controls Inc, a $700 million electronic components manufacturer, for this purpose. Since its inception, Porter’s markets have been expanding and the company has enjoyed growth in sales and earnings. Some of its earnings have been paid out in dividends, but some are also retained each year, causing its earnings per share and stock price to grow. The company began its life with only a few thousand shares outstanding, and after some years of growth, each of Porter’s shares had a very high EPS and DPS. When a ‘normal’ P/E ratio was applied, the derived market price was so high that few people could afford to buy a “round lot” of 100 shares. This limited the demand for the stock and thus kept the total market value of the firm below what it would have been if more shares, at a lower price had been outstanding. To correct this situation, Porter “split its stock” as described in the next section.

Stock Splits

Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, hence the firm’s value will be maximized. Many observers, including Porter’s management, believe that the best range for most stocks is from $20 to $80 per share. Accordingly if the price of Porter’s stock rose to $80, management would probably declare a two-for-one stock split, thus doubling the number of shares outstanding halving the earnings and dividends per share, and thereby lowering the stock price. Each stockholder would have more shares, but each share would be worth less. If the post-split price were $40, Porter’s stockholders would be exactly as well off as they were before the split, However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size-for example, the stock could be split two-for-one, three-for-one, one-and-a half-for-one, or in any other way.

Stock Dividends

Stock dividends are similar to stock splits in that they “divide the pie into smaller slices” without affecting the fundamental position of the current stockholders. On a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares (without cost); on a 20 percent stock dividend the same holder would receive 20 new shares; and so on. Again, the total number of shares is increased so earnings dividends and price per share all decline.

If a firm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis will keep the stock price more or less constrained. For example, if a firm’s earnings and dividends were growing at about 10 percent per year, its stock price would tend to go up at about that same rate, and it would soon be outside the desired trading range. A 10 percent annual stock dividend would maintain the stock price within the optimal trading range. Note, though that small stock dividends create bookkeeping problems and unnecessary expenses so firms today use stock splits far more often than stock dividends.