How Dividends Affect Stock Prices With Examples (2024)

Dividends can affect the price of their underlying stock in a variety of ways. While the dividend history of a given stock plays a general role in its popularity, the declaration and payment of dividends also have a specific and predictable effect on market prices. After the ex-dividend date, the share price of a stock usually drops by the amount of the dividend.

Key Takeaways

  • Companies pay dividends to distribute profits to shareholders, which also signals corporate health and earnings growth to investors.
  • Because share prices represent future cash flows, future dividend streams are incorporated into the share price, and discounted dividend models can help analyze a stock's value.
  • After a stock goes ex-dividend, the share price typically drops by the amount of the dividend paid to reflect the fact that new shareholders are not entitled to that payment.
  • Dividends paid out as stock instead of cash can dilute earnings, which can also have a negative impact on share prices in the short term.

How Dividends Work

For investors, dividends serve as a popular source of investment income. For the issuing company, they are a way to redistribute profits to shareholders as a means of thanking them for their support and encouraging additional investment.

Dividends also serve as an announcement of the company's success. Because dividends are issued from a company's retained earnings, only companies that are substantially profitable issue dividends with any consistency.

Dividends are often paid in cash, but they can also be issued in the form of additional shares of stock. In either case, the amount each investor receives is dependent on their current ownership stakes.

If a company has one million shares outstanding and declares a 50-cent dividend, then an investor with 100 shares receives $50 and the company pays out a total of $500,000. If it instead issues a 10% stock dividend, the same investor receives 10 additional shares, and the company doles out 100,000 new shares in total.

The Effect of Dividend Psychology

Stocks that pay consistent dividends are popular among investors. Though dividends are not guaranteed on common stock, many companies pride themselves on generously rewarding shareholders with consistentand sometimes increasingdividends each year.

Companies that do this are perceived as financially stable, and financially stable companies make for good investments, especially among buy-and-hold investors who are most likely to benefit from dividend payments.

When companies display consistent dividend histories, they become more attractive to investors. As more investors buy in to take advantage of this benefit of stock ownership, the stock price naturally increases, thereby reinforcing the belief that the stock is strong. If a company announces a higher-than-normal dividend, public sentiment tends to soar.

Conversely, when a company that traditionally pays dividends issues a lower-than-normal dividend or no dividend at all, it may be interpreted as a sign that the company has fallen on hard times.

The truth could be that the company's profits are being used for other purposessuch as funding expansionbut the market's perception of the situation is always more powerful than the truth. Many companies work hard to pay consistent dividends to avoid spooking investors, who may see a skipped dividend as darkly foreboding.

The Effect of Dividend Declaration on Stock Price

Before a dividend is distributed, the issuing company must first declare the dividend amount and the date when it will be paid. The last date when shares can be purchased to receive the dividend is the day before the ex-dividend date. The ex-dividend date is set based on stock exchange rules and generally falls one business day before the date of record, which is the date when the company reviews the list of shareholders on its books.

The declaration of a dividend naturally encourages investors to purchase stock. Because investors know that they will receive a dividend if they purchase the stock before the ex-dividend date, they are willing to pay a premium.

This causes the price of a stock to increase in the days leading up to the ex-dividend date. In general, the increase is about equal to the amount of the dividend, but the actual price change is based on market activity and not determined by any governing entity.

On the ex-date, investors may drive down the stock price by the amount of the dividend to account for the fact that new investors are not eligible to receive dividends and are therefore unwilling to pay a premium.

However, if the market is particularly optimistic about the stock leading up to the ex-dividend date, the price increase this creates may be larger than the actual dividend amount, resulting in a net increase despite the automatic reduction. If the dividend is small, the reduction may even go unnoticed due to the back and forth of normal trading.

Many people invest in certain stocks at certain times solely to collect dividend payments. Some investors purchase shares just before the ex-dividend date and then sell them again right after the date of record—a tactic that can result in a tidy profit if it is done correctly.

Stock Dividends

Though stock dividends do not result in any actual increase in value for investors at the time of issuance, they affect stock prices similar to that of cash dividends. After the declaration of a stock dividend, the stock's price often increases; however, because a stock dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.

As with cash dividends, smaller stock dividends can easily go unnoticed. A 2% stock dividend paid on shares trading at $200 only drops the price to $196.10, a reduction that could easily be the result of normal trading. However, a 35% stock dividend drops the price down to $148.15 per share, which is pretty hard to miss.

Dividend Yield/Payout Ratio

The dividend yield and dividend payout ratio (DPR) are two valuation ratios investors and analysts use to evaluate companies as investments for dividend income. The dividend yield shows the annual return per share owned that an investor realizes from cash dividend payments or the dividend investment return per dollar invested. It is expressed as a percentage and calculated as:

Dividendyield=annualdividendspersharepricepershare\begin{aligned}&\text{Dividend yield}=\frac{\text{annual dividends per share}}{\text{price per share}}\end{aligned}Dividendyield=pricepershareannualdividendspershare

The dividend yield provides a good basic measure for an investor to use in comparing the dividend income from his or her current holdings to potential dividend income available through investing in other equities or mutual funds.

Concerning overall investment returns, it is important to note that increases in share price reduce the dividend yield ratio even though the overall investment return from owning the stock may have improved substantially. Conversely, a drop in share price shows a higher dividend yield but may indicate the company is experiencing problems and lead to a lower total investment return.

The dividend payout ratio is considered more useful for evaluating a company's financial condition and the prospects for maintaining or improving its dividend payouts in the future. The dividend payout ratio reveals the percentage of net income a company is paying out in the form of dividends.

It is calculated using the following equation:

DPR=TotaldividendsNetincomewhere:DPR=Dividendpayoutratio\begin{aligned}&\text{DPR}=\frac{\text{Total dividends}}{\text{Net income}}\\&\textbf{where:}\\&\text{DPR}=\text{Dividend payout ratio}\end{aligned}DPR=NetincomeTotaldividendswhere:DPR=Dividendpayoutratio

If the dividend payout ratio is excessively high, it may indicate less likelihood a company will be able to sustain such dividend payouts in the future, because the company is using a smaller percentage of earnings to reinvest in company growth.

Therefore, a stable dividend payout ratio is commonly preferred over an unusually big one. A good way to determine if a company's payout ratio is a reasonable one is to compare the ratio to that of similar companies in the same industry.

Dividends Per Share

Dividends per share (DPS) measures the total amount of profits a company pays out to its shareholders, generally over a year, on a per-share basis. DPS can be calculated by subtracting the special dividends from the sum of all dividends over one year and dividing this figure by the outstanding shares.

DPS=DSDSwhere:D=sumofdividendsoveraperiod(usuallyaquarteroryear)SD=special,one-timedividendsintheperiodS=ordinarysharesoutstandingfortheperiod\begin{aligned} &\text{DPS} = \frac { \text{D} - \text{SD} }{ \text{S} } \\ &\textbf{where:} \\ &\text{D} = \text{sum of dividends over a period (usually} \\ &\text{a quarter or year)} \\ &\text{SD} = \text{special, one-time dividends in the period} \\ &\text{S} = \text{ordinary shares outstanding for the period} \\ \end{aligned}DPS=SDSDwhere:D=sumofdividendsoveraperiod(usuallyaquarteroryear)SD=special,one-timedividendsintheperiodS=ordinarysharesoutstandingfortheperiod

For example, company HIJ has five million outstanding shares and paid dividends of $2.5 million last year; no special dividends were paid. The DPS for company HIJ is 50 cents ($2,500,000 ÷ 5,000,000) per share. A company can decrease, increase, or eliminate all dividend payments at any time.

A company may cut or eliminate dividends when the economy is experiencing a downturn. Suppose a dividend-paying company is not earning enough; it may look to decrease or eliminate dividends because of the fall in sales and revenues. For example, if Company HIJ experiences a fall in profits due to a recession the next year, it may look to cut a portion of its dividends to reduce costs.

Another example would be if a company is paying too much in dividends. A company can gauge whether it is paying too much of its earnings to shareholders by using the payout ratio. For example, suppose company HIJ has a DPS of 50 cents per share and its earnings per share (EPS) is 45 cents per share. The payout ratio is 1.11% = (50/45); this figure shows that HIJ is paying out more to its shareholders than the amount it is earning. The company will look to cut or eliminate dividends because it should not be paying out more than it is earning.

The Dividend Discount Model

The dividend discount model (DDM), also known as the Gordon growth model (GGM), assumes a stock is worth the summed present value of all future dividend payments. This is a popular valuation method used by fundamental investors and value investors. In simplified theory, a company invests its assets to derive future returns, reinvests the necessary portion of those future returns to maintain and grow the firm, and transfers the balance of those returns to shareholders in the form of dividends.

According to the DDM, the value of a stock is calculated as a ratio with the next annual dividend in the numerator and the discount rate less the dividend growth rate in the denominator. To use this model, the company must pay a dividend and that dividend must grow at a regular rate over the long term. The discount rate must also be higher than the dividend growth rate for the model to be valid.

The DDM is solely concerned with providing an analysis of the value of a stock based solely on expected future income from dividends. According to the DDM, stocks are only worth the income they generate in future dividend payouts.

One of the most conservative metrics to value stocks, this model represents a financial theory that requires a significant amount of assumptions regarding a company’s dividend payments, patterns of growth, and future interest rates. Advocates believe projected future cash dividends are the only dependable appraisal of a company’s intrinsic value.

The DDM requires three pieces of data for its analysis, including the current or most recent dividend amount paid out by the company; the rate of growth of the dividend payments over the company's dividend history; and the required rate of return the investor wishes to make or considers minimally acceptable.

The current dividend payout can be found among a company's financial statements on the statement of cash flows. The rate of growth of dividend payments requires historical information about the company that can easily be found on any number of stock information websites. The required rate of return is determined by an individual investor or analyst based on a chosen investment strategy.

While the dividend discount model provides a solid approach for projecting future dividend income, it falls short as an equity valuation tool by failing to include any allowance for capital gains through appreciation in stock price.

What Are the Different Types of Dividends?

The different types of dividends are cash dividends (cash is paid out to the investor on each share), stock dividends (extra shares are provided to the investor), and scrip dividends (when a company has no cash and issues a promissory note to pay shareholders later).

Are Dividends Taxed?

Yes, dividends are taxed as income. Depending on the type of dividend, they are taxed at either ordinary income tax rates or capital gains tax rates. The latter applies if they are qualified dividends that meet certain requirements.

How Do Dividends Work?

Dividends are a payout to shareholders in the form of either cash or additional shares on every share they hold. A shareholder must have purchased a stock by a certain date to be eligible to receive the next dividend. Dividends are usually paid quarterly to shareholders.

The Bottom Line

Dividends can be an attractive feature of a stock for investors, particularly if they are following a dividend investment strategy. Before choosing a stock, determine how the dividend impacts its price and if it falls in line with your investment goals.

Correction—Nov. 30, 2023: This article has been corrected to state the last date when shares can be purchased to receive a dividend.

As an enthusiast and expert in finance and investing, I've spent years studying and analyzing various aspects of the financial markets, including dividend investing strategies, stock valuation models, and the impact of dividends on stock prices. My expertise in this field is backed by hands-on experience in analyzing financial data, researching market trends, and making investment decisions based on fundamental and technical analysis.

Now, let's delve into the concepts mentioned in the article about dividends and their effects on stock prices:

  1. Dividend History and Market Prices:

    • Companies pay dividends to distribute profits to shareholders, which also signals corporate health and earnings growth to investors.
    • Share prices represent future cash flows, and future dividend streams are incorporated into the share price. Discounted dividend models can help analyze a stock's value.
    • After the ex-dividend date, the share price typically drops by the amount of the dividend paid to reflect that new shareholders are not entitled to that payment.
  2. Dividend Types:

    • Dividends can be paid in cash or issued in the form of additional shares of stock.
    • Stock dividends can dilute earnings, potentially impacting share prices in the short term.
  3. Dividend Psychology:

    • Stocks that pay consistent dividends are popular among investors, signaling financial stability.
    • Consistent dividend histories make companies more attractive to investors, potentially leading to higher stock prices.
    • Public sentiment tends to soar when companies announce higher-than-normal dividends.
  4. Dividend Declaration and Stock Price:

    • The declaration of a dividend encourages investors to purchase stock, leading to a price increase before the ex-dividend date.
    • On the ex-dividend date, the stock price may drop by the amount of the dividend to account for new investors not being eligible for dividends.
  5. Stock Dividends:

    • Stock dividends increase the number of shares outstanding, leading to a reduction in the stock price.
    • Smaller stock dividends may go unnoticed, while larger ones can significantly impact the stock price.
  6. Dividend Yield and Payout Ratio:

    • Dividend yield shows the annual return per share owned from cash dividend payments.
    • The dividend payout ratio reveals the percentage of net income a company is paying out in dividends.
  7. Dividends Per Share (DPS):

    • DPS measures the total amount of profits a company pays out to its shareholders on a per-share basis.
    • DPS can fluctuate based on company performance and dividend policies.
  8. Dividend Discount Model (DDM):

    • DDM assumes a stock's value is the present value of all future dividend payments.
    • DDM requires data on current dividends, dividend growth rate, and investor's required rate of return.
  9. Types of Dividends:

    • Cash dividends, stock dividends, and scrip dividends are the main types.
  10. Taxation of Dividends:

    • Dividends are taxed as income, either at ordinary income tax rates or capital gains tax rates for qualified dividends.
  11. How Dividends Work:

    • Dividends are payouts to shareholders in the form of cash or additional shares, usually paid quarterly.

In conclusion, understanding dividends and their impact on stock prices is crucial for investors looking to build a well-rounded investment portfolio. From dividend psychology to valuation models like the DDM, these concepts provide valuable insights into the dynamics of dividend-paying stocks in the financial markets.

How Dividends Affect Stock Prices With Examples (2024)

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