A stock split or stock divide increases the number of shares in a public company. Suppose a company has 1,000 shares outstanding. The company may want to increase this number to 2,000 shares without issuing new shares. They would split their stock 2-for-1. That means that every shareholder trades in one old share and gets two new shares in return.
The ownership stake for each shareholder remains constant because the number of shares held changes in proportion to the number of shares outstanding. They own the same percentage of the outstanding shares, though the nominal number of shares increases.
The price of the shares, however, changes. Since the market value of the company remains the same, the price of the new shares adjusts to reflect the new number of outstanding shares.
EXAMPLEA company that has 100,000 shares outstanding that trade at $6 has a market capitalization of $600,000. After a 3-for-1 stock split, the market capitalization of the company remains unchanged at $600,000, but there are now 300,000 shares trading at $2.
In lieu of cash, a company may choose to pay its dividend in the form of stock. Instead of each shareholder receiving, for instance, $2 for each share, they may receive an additional share. A stock dividend (also known as a scrip dividend) can be the economic equivalent of a stock split.
When a stock dividend is paid, no shareholder actually increases the values of his or her assets. The total number of shares outstanding increases in proportion to the change in the number of shares held by each shareholder.
EXAMPLEIf a 5% stock dividend is paid, the total number of shares outstanding increases by 5%, and each shareholder will receive 5 additional shares for each 100 held. As a result, each shareholder has the same ownership stake as before the stock dividend.
In addition, the value of the shares held does not change for each shareholder. As the number of shares outstanding increases, the price per share drops because the market capitalization does not change. Therefore, each shareholder will hold more shares, but each has a lower price so the total value of the shares remains unchanged.
The stock dividend is not, however, exactly the same as a stock split. A stock split is paid by switching out old shares for a greater number of new shares. The company is essentially converting to a new set of shares and asking each shareholder to trade in the old ones. A stock dividend could be paid from shares not outstanding. These are the company’s own shares that it holds; they are not circulating in the market, but were issued just the same. The company may have gotten these shares from share repurchases, or simply from them not being sold when issued.
Stock dividends may also be paid from non-outstanding stock or from the stock of another company (e.g., its subsidiary). The company would record the stock dividend as a debit to the retained earnings account and credit both common stock and the paid in capital accounts.
By owning a share, the shareholder owns a percentage of the company whose share they own. A share, however, does entitle the shareholder to a specific percentage ownership; the amount of the company that the shareholder owns is dependent of the number of shares owned and the number of shares outstanding.
EXAMPLEIf Jim owns 10 shares of Oracle, and there are 1,000 shares outstanding, Jim effectively owns 1% of Oracle. If the number of shares outstanding were to double to 2,000, Jim’s 10 shares would now correspond to a 0.5% ownership stake. In order for Jim’s ownership stake to remain constant, the number of shares he holds must change in proportion to change in outstanding shares: he must own 20 shares if there are 2,000 shares outstanding.
That is the premise behind a reverse stock split. In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.
The reduction in the number of issued shares is accompanied by a proportional increase in the share price.
EXAMPLEA company with a market capitalization of $1,000,000 from 1,000,000 shares trading at $1 chooses to reduce the number of outstanding shares to 500,000 through a reverse split. This leads to a corresponding rise in the stock price to $2.
There is a stigma attached to doing a reverse stock split, so it is not initiated without very good reason and may take a shareholder or board meeting for consent. Many institutional investors and mutual funds, for instance, have rules against purchasing a stock whose price is below some minimum. In an extreme case, a company whose share price has dropped so low that it is in danger of being delisted from its stock exchange might use a reverse stock split to increase its share price. For these reasons, a reverse stock split is often an indication that a company is in financial trouble.
A reverse stock split may be used to reduce the number of shareholders. If a company completes a reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment. If the number of shareholders drops, the company may be placed into different regulatory categories and may be governed by different laws.
An alternative to cash dividends is share repurchases. In a share repurchase, the issuing company purchases its own publicly traded shares, thus reducing the number of shares outstanding. The company then can either retire the shares, or hold them as treasury stock (non-circulating, but available for re-issuance).
When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase. Repurchasing shares when a company’s share price is undervalued benefits non-selling shareholders and extracts value from shareholders who sell.
Repurchasing shares will lead to a corresponding increase in price of the shares still outstanding. The market capitalization of the company is unchanged, meaning that a reduction in the number of shares outstanding must be accompanied by an increase in stock price.
There are six primary repurchasing methods:
|Open Market||The firm buys its stock on the open market from shareholders when the price is favorable. This method is used for almost 75% of all repurchases.|
|Selective Buy-Backs||The firm makes repurchase offers privately to some shareholders.|
|Repurchase Put Rights||Put rights are the right of the seller to purchase at a certain price, set ahead of time. If the company has put rights on its shares, it may use them to repurchase shares at that price.|
|Fixed Price Tender Offer||The firm announces a number of shares it is looking for and a fixed price they are willing to pay. Shareholders decide whether or not to sell their shares to the company.|
|Dutch Auction Self-Tender Repurchase||The company announces a range of prices at which they are willing to repurchase. Shareholders voluntarily state the price at which they individually are willing to sell. The company then constructs the supply curve, and announces the purchase price. The company repurchases shares from all shareholders who stated a price at or below that repurchase price.|
|Employee Share Scheme Buy-Back||The company repurchases shares held by or for employees or salaried directors of the company.|
Shares may be repurchased if the management of the company feels that the company’s stock is undervalued in the market. It repurchases the shares with the intention of selling them once the market price of the shares increases to accurately reflect their true value. Not every shareholder, however, has a fair shot at knowing whether the repurchase price is fair. The repurchasing of the shares benefits the non-selling shareholders and extracts value from shareholders who sell. This gives insiders an advantage because they are more likely to know whether they should sell their shares to the company.
Furthermore, share repurchases can be used to manipulate financial metrics. All financial ratios that include the number of shares outstanding (notably earnings per share, or EPS) will be affected by share repurchases. Since compensation may be tied to reaching a high enough EPS number, there is an incentive for executives and management to try to boost EPS by repurchasing shares. Inaccurate EPS numbers are not good for investors because they imply a degree of financial health that may not exist.
From the investor’s perspective, one negative consequence of a share repurchase is it is difficult to foresee how this will impact that company’s valuation. It is common for companies to announce a repurchase agreement but not fully complete the repurchase. This can create additional difficulty for shareholders to accurately evaluate the value of the organization.
In some instances, a company may offer its shareholders an alternative option to receiving cash dividends. The shareholder chooses to not receive dividends directly as cash; instead, the shareholder’s dividends are directly reinvested in the underlying equity. This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).
The purpose of the DRIP is to allow the shareholder to immediately reinvest their dividends in the company. Should the shareholder choose to do this on their own, they would have to wait until enough cash accumulates to buy a whole number of shares and they would also incur brokerage fees.
EXAMPLEBrokerage firms like Charles Schwab earn money by charging a brokerage fee for executing transactions. Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.
Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder. Some DRIPs are free of charge for participants, while others do charge fees and/or proportional commissions.
Regardless, DRIPs have become more and more popular for a variety of investors. Chief among these is due to dollar-cost averaging, typically with regard to corporate dividends. This creates a scenario in which the investor is guaranteed the return of the dividend yield, as well as whatever amount the stock may appreciate to. The risk involved is the possibility the stock may depreciate, as well.
There is also an advantage to the company managing the DRIP. DRIPs inherently encourage long-term investment in the shares, which helps to mitigate some of the volatility associated with active trading. DRIPs help to stabilize the stock price.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Cash Dividend Alternatives” TUTORIAL.