Dividend Policy, Stock Dividends, and Stock Splits

Key Insight

Historically, dividend policy was a frequent subject of debate, with shareholders typically advocating for more liberal payouts while managements preferred retaining earnings to 'strengthen the company,' often asking shareholders to sacrifice immediate interests for future long-term benefits. However, investor attitudes towards dividends have notably evolved. The modern justification for smaller dividends often focuses on a company's ability to reinvest funds for profitable expansion that directly benefits shareholders, rather than simply claiming the company 'needs' the money. Previously, weak companies retaining profits usually saw adverse effects on their market price. Now, strong, growing enterprises deliberately maintain low dividend payments, often with investor and speculator approval, embracing the 'profitable reinvestment' theory. This shift has led to instances where for many 'growth favorites,' the dividend rate or even its absence has had virtually no impact on market price, exemplified by Texas Instruments, whose stock rose from 5 in 1953 to 256 in 1960 with no dividends, and Superior Oil, which sold at 2000 in 1957 without paying any dividend.

Investment sentiment regarding dividend policy for growth companies remains unconsolidated. The market generally categorizes non-growth stocks as 'income issues,' where the dividend rate significantly dictates market price. Conversely, for rapid-growth companies, valuation is primarily based on anticipated growth rates over, for instance, the next decade, rendering the cash dividend rate less relevant. Many companies fall into an intermediate category, making the market's assessment of the growth factor's importance variable year-to-year. A paradox also exists, where slower-growth, often less prosperous, companies are paradoxically expected to offer more liberal cash dividends, despite historical trends linking greater prosperity to higher and increasing payments. Therefore, shareholders are justified in demanding either a normal payout, around two-thirds of earnings, or a clear demonstration that reinvested profits have yielded a satisfactory increase in per-share earnings. When a low payout policy results in an average market price below fair value, especially when imposed by unprosperous companies for expansion, shareholders have a right to inquire and complain.

Investors must clearly understand the distinction between a stock dividend and a stock split. A stock split is a restatement of the common stock structure, typically involving issuing multiple new shares for one existing share, primarily to achieve a lower, more accessible market price per share, and is not directly tied to specific earnings from a past period. Conversely, a 'proper' stock dividend serves as tangible evidence or a representation of specific earnings recently reinvested in the business, usually over a short period not exceeding the two preceding years. Such a dividend is valued at its approximate market value at the time of declaration, with an equal amount transferred from earned surplus to capital accounts; it is typically small, often not more than 5%. While its overall effect is comparable to a cash dividend accompanied by the sale of additional shares of like total value, a key advantage of a straight stock dividend is its tax benefit compared to the cash dividend-plus-stock-subscription-rights model prevalent in public utilities. Despite academic criticisms deeming stock dividends as mere 'pieces of paper,' they offer practical value by allowing shareholders to easily convert reinvested profits into cash by selling new certificates, while usually maintaining the same cash-dividend rate on the increased number of shares. This systematic policy of paying stock dividends to capitalize reinvested earnings could lead to enormous aggregate income tax savings for shareholders, particularly if adopted by public utilities, as it addresses the inequity of taxing earnings that are effectively reclaimed by companies through stock sales.