Cash dividends are, of course, the surest way to build wealth.

— Roger Conrad

The bigger the company, the more likely it is to pay a dividend. Whereas more than three-quarters of the companies in the S&P 500 pay a dividend, only about half of all U.S.-listed firms pay one. According to academic studies from 2005 (p. 797) and 2010, of those companies that do pay a dividend, the vast majority pay out cash, but 8% pay out dividends in the form of additional shares of stock:

Recent examples of companies that pay stock dividends include Southside Bancshares (NasdaqGS: SBSI), TGC Industries (NasdaqGS: TGE), Parke Bancorp (NasdaqCM: PKBK), and Fort Orange Financial (OTC BB: FOFC.OB),

Why would a company – or an investor – prefer one type of dividend over the other? And what’s the difference between a cash dividend and a stock dividend?

Mechanics of Stock Dividends

A stock dividend is similar to a stock split — a company issues new shares to stockholders in some proportion to the shares outstanding. Any stock dilution of 25% or greater is considered a split, so a 5-for-4 exchange is a stock split, not a stock dividend. Stock splits simply reduce the par value per share of stock outstanding. In contrast, stock dividends require the shifting of retained earnings into the company’s capital stock account, which reduces the cash available to pay out classified as a dividend. Cash paid out that is greater than retained earnings is classified as a return of capital.

Most stock dividends are in the 5% to 15% range. If a company pays a 5% stock dividend, each shareholder will receive one new share for every 20 shares they own. So a shareholder with 100 shares will own 105 shares after the dividend is paid. The total value of the firm does not change:

Neither a cash nor a stock dividend changes the shareholder’s net worth in the company. Cash-rich firms favor cash dividends, while growing firms or firms seeking to reduce their share prices may opt for stock dividends. A stock dividend is not taxable until sold – that is, if stock is the only option offered. Shareholders that are given the option of receiving either stock or cash dividends will be taxed even if they choose stock. In contrast, a cash dividend is always immediately taxable.

Note: the cash distributions of MLPs are not considered dividends and are almost entirely tax-deferred! Check out our free MLP Investing report to learn more about the advantages of investing in MLPs.

Stock dividend proponents argue that a stock dividend gives shareholders maximum flexibility – if they want to reinvest in the business tax-free, they can hold onto the stock. If they want to cash out, they can sell the shares. I guess holding on to a stock dividend can be considered a form of reinvestment, but keep in mind that it is a type of reinvestment that just maintains – and does not increase – one’s ownership stake in the company.

Cash is King

Cash dividend proponents (including me) argue that requiring a company to return cash imposes fiscal discipline and prevents the company from squandering shareholder wealth. Furthermore, since many shareholder recipients of cash dividends do not reinvest them (silly them!), those that do reinvest gain a greater share of future company profits. And if you reinvest the cash when the stock price is low, all the better!

In contrast, recipients of stock dividends cannot increase their ownership stake in the company without shelling out additional cash from their pocket.

Others argue that you don’t need either type of dividend to cash out because you can always sell existing shares. This is true, but it requires more work on the shareholder’s part to remember to sell shares on a regular basis. Dividends (especially of the cash variety) do the work for you.

Bottom Line: What Floats Your Boat?

It all comes down to your evaluation of management’s capital allocation skills (and integrity), the company’s legitimate cash needs, and your own cash needs. Personally, I think cash dividends keep management honest and I want to own companies that pay them even if I don’t need the cash. I also like to increase my ownership stakes in solid companies without the need to find new cash.

Editor’s note: Uncover 5 of our favorite dividend stocks by checking out our Top 5 Dividend-Paying Companies report.