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How Dividends Affect Stock Prices

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 has a specific and predictable effect on market prices.

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 way to thank them for their support and to encourage 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. It also announces the last date when shares can be purchased to receive the dividend, called the ex-dividenddate. This date is generally two business days prior to the date of record, which is the date when the company reviews its list of shareholders.

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-dividend 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 for the purpose of collecting 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 have an affect on stock price 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, a reduction that could easily be the result of normal trading. However, a 35% stock dividend drops the price down to $130 per share, which is pretty hard to miss.

Dividend Yield/Payout Ratio

The dividend yield and dividend payout ratio 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: