Cash Dinidends Versus Stock Dividends

by ARTHUR W. JOYCE

IT has so long been the custom for corporations to distribute regular dividends in cash that the comparatively recent tendency to distribute dividends in stock becomes a sharp exception to the general rule. Its unpopularity with most investors as a substitute for a dividend check is not unnatural, because there is something very satisfying about the arrival of dividend checks, but the regular stock dividend’s unpopularity goes farther, and assumes the form of a strong adverse prejudice which doubtless rests upon either a misunderstanding of its character or a downright suspicion regarding its legitimacy. This prejudice affords an amusing contrast to the enthusiasm with which an occasional major stock dividend is acclaimed, despite the fact that neither the one nor the other makes the slightest difference in the intrinsic value of the stock affected. The general character of a cash dividend is so essentially simple that analysis of its functions by the stockholder seldom goes beyond an expression of satisfaction, but the stock dividend is not quite so obvious, so that a word as to its real character is essential to a proper recognition of its usefulness.

In the first place, the inclusion of the word ‘dividend’ in the term ‘stock dividend’ should be sufficient to indicate that the distribution must come from earnings, past or current — otherwise, it cannot be classified as a dividend at all. This fact, which is not altered by either the size or the regularity of the stock dividend, is basic. Any distribution to stockholders as a dividend which does not actually emanate from earnings present or past constitutes willful misrepresentation of a variety not associated with honest management or approved by reliable accountants.

THERE is a sharp distinction between a stock dividend and a stock split-up. If a corporation having 10,000 shares of stock carried in t lie capital account at $1,000,000, and a surplus of $3,000,000, declares a 100 per cent stock dividend, its capital account becomes 20,000 shares carried at $2,000,000, but its surplus account declines to $2,000,000. It has thus capitalized earnings of $1,000,000. If, however, this same corporation were to split its stock two for one, there would be no alteration in any of its balance-sheet accounts, save only the increase in the number of shares. Indeed, in the latter case, the split-up in no sense requires the presence of a surplus account at all. These two acts, while possibly of similar practical effect in the hands of the stockholder, differ in motive. The stock dividend is primarily a distribution of earnings, and only secondarily a device to facilitate ownership among a larger number of investors in Consequence of a lowering in market price, whereas the stock split-up has nothing to do with earnings, being solely a device for facilitating distribution. (The purpose in thus comparing these two acts is not to quibble over their practical effect, but to throw the genuine stock dividend into sharper relief for further observation.)

GRANTING that the regular stock dividend represents a distribution of earnings, the question arises as to the motive in distributing earnings by this method rather than in cash. The answer is based upon the recognition that the regular stock dividend is more naturally characteristic of a holding company than, of an operating company. These two types are fundamentally different. The operating company is a producing organization. Its assets are tangible things, such as real estate and machinery, whose very nature precludes the probability that their intrinsic value will ever increase materially. Such assets are valuable because of their productive earning power, and even then they become less valuable through depreciation and obsolescence. Their earning power takes the form of cash profits only, and for this reason it is logical that distribution of dividends to stockholders should likewise he in cash, especially since no valid reason exists for departing from this procedure.

In contrast to this, the holding company is not a producing organization — it is a financial organization. Its assets are intangible, normally consisting of large holdings of common stocks of its subsidiaries, involving either majority control or substantial influence through large minority ownership, and in either event owned as a fairly permanent matter. The very nature of these assets includes distinct promise of enhancement in value as the main reason for owning them. Such future enhancement may very readily occur notwithstanding an immediate cash return of very small proportions, and may be much more valuable potentially than the cash income, although the two are naturally interrelated. Moreover, the holding company, far from desiring to sell any of its major assets at a profit in order to augment a comparatively low cash income, is frequently faced with the pleasant necessity of increasing its investment in its subsidiary holdings, in order to maintain its relative degree of ownership in companies whose continued growth results in enlarged capital structures. This latter condition naturally dictates conservation of cash assets by the holding company, rather than their distribution as dividends, in order to facilitate the banking aspect of the holding company’s functions. All these things being true, the distribution of a regular dividend in stock becomes perfectly logical, at least until such time as the holding company begins to receive an actual cash income in excess of its own reasonable expansion needs.

UPON this background, it becomes interesting to examine the fairly universal criticism that the regular stock dividend is a device for paying out to stockholders more money than the corporation earns. This misapprehension, while needless, nevertheless rests upon ground which, at first glance, seems to support it, for it is usually a fact that the actual market value of the regular stock dividend exceeds the corporation’s current earning power. This confusing condition introduces a comparison between actual earnings and the market appraisal of the stock which produces the earnings.

For example, assume that X Corporation, paying regular dividends in stock at the annual rate of 6 per cent, is actually earning two dollars per share in cash annually, and assume also that this corporation’s position and prospects are such that the investing public considers fifty dollars per share as a fair price for its stock. The 6 per cent stock dividend becomes worth three dollars marketwise, whereas the earnings are only two dollars, but it by no means follows that this corporation is paying out three dollars for every two dollars received. Doubtless this corporation carries its stock in its capital account at a figure very much lower than the market appraisal of fifty dollars — indeed, it may conceivably carry the stock at twenty dollars per share without in the least indicating thereby that the stock’s book value is not considerably higher, or that the market price of fifty dollars is wrong. Under conservative accounting, the regular per 6 cent stock dividend would be charged to capital account at the same rate that the previously issued shares were charged at — namely, twenty dollars; and 6 per cent of twenty dollars is $1.20, which is well within the corporation’s actual earning power. The reason why such a regular stock dividend, costing the corporation $1.20, and offset by earnings of two dollars, sells in the open market at three dollars is identical with the reason why the market value of the outstanding shares is substantially higher than the value at which they are carried in the capital account.

Any stockholder receiving regular stock dividends may readily tell whether his corporation’s use of such a policy is constructive. If, at the end of a given fiscal year, the book value of all the outstanding stock (including that which was outstanding at the beginning of the year, plus the increase by stock dividends) is greater per share than at the beginning, obviously the stockholder is better off. If these two values are identical, then the stockholder is neither better nor worse off. If, however, the end-of-the-year figure shows a shrinkage, positively traceable to the dividend policy, then the stockholder is losing, and should interpret this loss as a warning.

The regular stock dividend is also criticized because its use has a tendency to inflate the market price for the stock, in that rising prices for the stock bring about increased market value for the dividend, which in turn influences still higher prices for the stock. Phis tendency exists beyond dispute, but it is decidedly shortsighted to criticize the policy as one intended to exploit this tendency, for it must be remembered that under falling market conditions the above tendency reverses itself with absolutely identical force. Another criticism is that unless the stockholder retains his periodic increases in stock, he reduces his degree of ownership, and that if he does retain them, rather than sell them for cash, he forgoes all income. This objection seems to gather force by comparison with the ordinary dividendin-cash policy, in which the stockholder retains his percentage of ownership and get his cash income in addition, but it errs in accepting the apparent results of the cash-dividend policy as an altogether perfect condition. No one can have his cake and eat it.

Applied to stockholders, this observation discloses the fact that it is impossible for any corporation actually to give its stockholders anything in the nature of a dividend which they did not already possess as stockholders. If it pays them a cash dividend, the assets of the corporation immediately decline by the exact amount of the payment, so that what actually occurs is merely a change of title to this portion of assets. If the corpora tion pays a stock dividend, it is somewhat more obvious that the stockholder has not received anything which was not already his, for the stock dividend is only a certified expression of a previously existing fact. (Here again, this technical analysis is not prompted by a desire to quibble over practical results, and is presented solely because it has a definite bearing upon the character of a stock dividend.)

FINALLY, it is so universally recognized that the dividend-in-cash policy, as it is applied to the vast majority of corporations, is a practical and well-balanced procedure, and one which is entirely acceptable in its results, that it would be a waste of time to dispute it. For this reason, the writer has no fear that his comments upon it above can, in fairness, be interpreted otherwise than as necessary in the attempt to remove some of the fog now surrounding the newer dividend-in-stock policy. The proper limits of the latter are obvious, but its use within these limits simply involves recognition of changing conditions, to which it is both readily and logically adaptable.