What Are Stock Dividends?
Corporate profits that are paid out to stockholders are called
dividends.
A corporation does not generally pay a dividend until:
- Gross receipts are larger than is required to meet all expenses, including taxes and paying interest on borrowed money. The remainder is the corporation’s net income or net profit, sometimes called “earnings.”
- Management decides to pay a dividend. The company considers such things as how much profit is needed for re-investment into the business, for expansion of the business, or as a cushion for possible bad years in the future, and how much net income can be used for dividends to stockholders.
Sometimes, when current income is poor, dividends are paid from the undistributed profits of previous good years.
Not all companies that are able to pay dividends, pay dividends.
Common and Preferred Stock
Every corporation has
common stock. In the simplest form of equity ownership, a company has only common stock. A company with two classes of stock can have
preferred shares as well.
Preferred stock is a compromise between a loan and equity. A preferred dividend is scheduled at a uniform rate per share, such as five dollars a year, thus resembling interest on a bond. In contrast to bond interest, a corporation pays a preferred dividend only if earnings have been adequate and management decides to pay. This uncertainty of dividends causes more fluctuation in the market price of preferred stock than on bonds issued by corporations, although probably not as much as on the common stock of the same corporations.
When a company’s net income goes up, the dividend on a share of preferred stock remains at the scheduled rate. However, on a common share increased profits possibly lead to a larger dividend, and the market price of a common share rises more than on the preferred share.
In a prosperous period, both the dividend and market value on a share of common stock may be higher than on the preferred stock, thus leaving a preferred stockholder in a state of genteel poverty. When profits are poor, dividends might continue on the preferred stock but not on the common stock. Or, dividend payment might stop on both classes of stock. Usually the only thing sure about preferred stock is that the dividend will not be higher than the scheduled rate.
For an amateur investor, a simple way to deal with this confusing situation is just not owning any preferred stock. Because the existence of a preferred class complicates the normal relation between company earnings and common stock dividends, an amateur investor should be skeptical of common stock in a corporation that also has preferred stock. Most large American corporations have only common stock. So throughout this site, the discussion of stock is limited to the common class only.
Early in the 20th century a corporation customarily sold a new issue of stock at the par value, usually $100 a share. Then, par value had some meaning for an investor. But today the par value of a share of common stock indicates neither the original price nor the present selling price. It has become merely a legal technicality. A number of corporations specify that their stock has “no par value.”
To an investor, the market price of a share is what matters. On common stock in a prosperous period this value is likely to be a good deal higher than the par value.
