| Web Site Index Page | Stock Splits | Links and Sources |
The Effect Of Stock Splits & Stock
Dividends On The Market Share Price
As we know, stock splits are the partitioning of the outstanding shares of a corporation into a larger number of shares, while proportionately decreasing the market price. Again, stock splits do not affect the equity of the company.
Stock dividends do affect the distributable equity (or the equity of the company that can be distributed to shareholders in the form of dividends) of the company. Simply, a stock dividend is a reduction of distributable equity. Distributable equity includes the balance in Retained Earnings and/or Paid-in Capital, depending on the state of incorporation.
Stock distributions are typically classified into two categories: small stock distributions (less than 25 percent) and large stock distributions (greater than 25 percent). Gathered from cumulative research over the years, most small stock distributions are accounted for as stock dividends and large stock distributions are accounted for as stock splits, but this estimation is not completely valid, especially for large stock distributions. Managers of corporations have a choice of using their preferred accounting method, but firms paying small stock dividends are required by law to account for the distribution by transferring the value from retained earnings to the contributed capital accounts (common stock and paid-in capital). Hence, since managers cannot choose how to account for small stock distributions for their company, one cannot speculate on the connotation of the distribution.
However, corporations do choose their own methods in accounting for large stock distributions (greater than 25 percent). According to Craig Peterson and James Millar, management of a corporation may select one of three different methods in accounting for large stock distributions:
Therefore, a corporation chooses each of these methods for different reasons, and some people believe that observation and analysis of a company's accounting activities in this respect can be very informative.
Craig Peterson and James Millar published an article, in the American Accounting Association's Accounting Review, in which they performed an extensive trial. Peterson and Millar carefully selected a sample of 285 different companies that had large stock distribution events, selecting their sample based on firms with non-confounding announcements, bounded state corporate laws, and sufficient and clear accounting practices and methods. As a result, the article states that, in contrast with prior research, the plurality of large stock distributions is not accounted for as stock splits, although they may be announced as stock splits. Rather, these distributions are accounted for as stock dividends. The Accounting Review article states that the AR (the avg. market return from the day prior to, and including, the announcement date) for the sample yielded a 1.52% return, with 75% of the events yielding a positive AR. Additionally, the AR of the accounting methods that reduced distributable equity (1.74%) appreciated significantly in comparison to the events that did not (1.06%).
Accordingly, when a company chooses a stock distribution accounting method that decreases distributable equity this seemingly signals a positive sign for the company's confidence and potential for future profits. This can be concluded as a positive sign because reducing distributable equity means that the company is giving up its potential cash dividends. More accurately, this activity implies that if the company would decrease its retained earnings or paid-in capital account, then, the company must be confident that it can easily replenish those accounts since the corporation will eventually have to use the accounts to pay dividends in arrears, etc.
In conclusion, the concept of stock distributions is a very important dynamic to understand. With this knowledge, one can be better prepared to speculate on a company and forecast its future results more accurately. There is a significant contrast of opinions within the financial arena about these issues. Essentially, there is no proven way to speculate correctly on issues with so many variables as in the stock market. There are many Internet sites in operation now, which offer supposedly irresistible solutions to making money on trading off stock splits and other things. Unfortunately, like us all, they have not discovered an airtight answer to profiting from this type of speculation; otherwise, if that were true, no one would be working.