Types of Dividends
We describe different types of dividends that investors may receive when they own stocks. In particular, we discuss regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits on shareholders’ wealth and a company’s financial ratios.
Regular cash dividends
Regular cash dividends are periodic dividend payments that are made in cash. Generally, companies strive for stability in their regular dividends. Firms tend to increase them slowly and refrain from any reductions. Stable or increasing dividends that are paid regularly are perceived as a sign of consistent (and growing) profitability.
In some countries, companies can have dividend reinvestment plans (DRPs) that, at shareholders’ request, automatically reinvest all or part of the regular cash dividend by purchasing additional stocks. The additional stocks can be purchased in the open market (open market DRP) or can be newly issued (as in a new issue DRP, or scrip dividend scheme in the U.K.) by the company.
What are the advantages of a DRP?
- For the company, a DRP promotes a diverse shareholder base because DRPs provide a cost effective opportunity for retail investors to accumulate stock. DRPs also promote long-term investment. New issue DRPs allow companies to raise additional capital without the floatation cost of a secondary offering.
- DRPs offer shareholders a number of potential advantages. First DRPs generally allow for purchase of additional shares with no transaction costs. Second, DRPs allow shareholders to benefit from cost averaging. And third, the shares are sometimes offered to DRP participants at a discount to market price.
The main advantage of DRPs is that shareholders may have to cope with additional record keeping for tax purposes. Dividends reinvested at a market price higher than the original purchase price increase the average cost basis. Additionally, dividends are fully taxed in the year they are paid, even if they are reinvested. Therefore, it makes sense to hold DRPs in tax-sheltered accounts.
Extra or special (irregular) dividends
This is a cash dividend that supplements regular dividends or a dividend of a company that normally does not pay dividends, is known as a special dividend. Special dividends are paid under unusual circumstances (e.g., when the company sells off a division) under the expectation that the dividend is not recurring.
Extra dividends may be paid if the company had an especially profitable year, but does not want to commit to a higher ongoing regular dividend payment.
A liquidating dividend is paid by a firm when the whole firm or part of the firm is sold or when dividends in excess of cumulative retained earnings are paid (resulting in a reduction of stated capital). Note that a liquidating dividend is considered a return of capital rather than a return on capital.
A non-cash dividend paid in the form of additional shares is called a stock dividend. After payment of a stock dividend, shareholders have more shares and the cost per share will be lower (while the total cost basis remains the same). Shareholders’ proportionate ownership of the company does not change, because every shareholder receives the same percentage stock dividend.
Shareholders are usually not taxed on stock dividends. Because the market value of the company is unchanged, the market price per share declines leaving the shareholders with no net gain.
Stock splits are similar to stock dividends (non-cash) but generally larger in size. A two-for-one stock split is the same as a 100% stock dividend. Reverse stock dividends reduce the number of shares outstanding and increase the price per share.
We discussed five types of dividends that companies use to pay out dividends to shareholders.