Every investor gets into the universe of share market investment for different reasons. Some investors go in for stock investment purely because they are interested in the consistency of the dividends received from the investment. This acts as a source of income for many investors who may possess solid large-cap stocks. In stock market trading, even when new investors enter the markets, they may do so by selecting stocks of companies that show a consistent generation of dividend history. Such company stock is attractive to investors. Even if the stock may be held for a long period before yielding any significant returns, investors are satisfied if it generates high dividends from time to time.
Who wouldn’t like some extra payout now and then? If you are one of those traders who have an investment strategy based on sound income generation, you might have to look for the shares of those companies which issue dividends. But before one goes ahead and makes a pick for the investment, it is also essential to know how the dividends would fit into one’s portfolio and how they matter to the stock market trading.
Most of the investors who have their interest in dividends always have a similar question, i.e. how do dividends affect stock prices? To understand the answer to this, one should know the major difference between expected and unexpected price changes.
What happens when a dividend is declared?
Before any stock dividend gets distributed, the company that issues it has to declare it. Without this declaration, a dividend cannot be issued and given out to stockholders. The declaration has the date of the issue of the dividend and the amount of the dividend. What the declaration also announces is the end date by which stocks may be purchased if any investor wishes to receive the dividend (the date is known as the ex-dividend date). This date typically falls on a single business date before the record date on which a company holds a review of its shareholder list. The declaration itself affects the price of the stock.
Naturally, when the declaration of a dividend is made, it compels individuals to purchase the stock. As investors clearly know that they will get dividends in the event they buy the stock before the stipulated date, they don’t mind paying a premium price for any stock in question. Obviously, in this scenario, the stock price rises. So, in the days just ahead of the date of dividend generation, the price of the stock goes up. Some investors take advantage of this and sell the shares at this time just to make substantial gains.
Let us now have a look at five ways company dividends affect the price of the stock :
1. Discover the stock’s share price
The prices of the shares fluctuate every second in stock markets, and this makes it hard for the experts to know the right price to purchase the stocks. Trade analysts make use of various models to identify the right price of the share. One such method is based entirely on dividends. This method says that the right share price is the present value of all those future dividends. So, if the dividends are higher, one can expect an increase in the share price too. However, in India, a number of companies also reinvest the profits for business growth. Thus they only give out a small portion of their profits as dividends to their investors.
2. The Ex-dividend price
The prices of the shares normally see a rise when the company is about to announce the dividends. Once the dividends are distributed, the share price plummets immediately. In many cases, this fall in the share price is almost equal to the dividend that has been announced. For example, if company X has distributed dividends worth Rs. 50, one can most likely expect a fall in the stock price by the same amount one day after the distribution has been done. This price is called the ex-dividend price.
3. The Dividend rally
It is a well-known fact that not every trader follows the same strategy to make money in stock markets during stock market trading. While some buy the shares and hold on to them for many years, others prefer day trading or hold their stocks short term to make some quick bucks. One such strategy used by traders to earn quickly is to make the best use of the dividend rally. Traders thus buy the shares at least a month before the dividend is announced. The news of a dividend being announced increases the price of the stock. Once the dividend is distributed, the traders then sell the shares and earn good profits. This is just another way in which a dividend affects the prices of the shares.
4. The Dividend yield
While the above-mentioned are some of those factors and strategies, which show how dividends affect stock prices, there is also another strategy which is used by many investors. These traders invest only in those companies which announce good dividends, and they also keep in mind the price of the share of that company. They compare the dividends by using Dividend yield. One can get the dividend yield by dividing the dividend amount and the share price, and the result is multiplied by 100. The investors who invest in companies which show a proven historical record of good dividend yields don’t mind if they cannot sell the shares to earn rich rewards soon. The solid dividends they get regularly are good enough returns on their stock investment.
5. The change of stock prices on the dividend day
Whenever a company declares the dividend, the amount can be either higher or lower than expected. This can show a huge impact on the stock price, and it can fluctuate based on the declaration made. We can take an example of two scenarios here:
Dividend announced is lower than expected: When a company XYZ announces the dividend, which is lower than what was expected, it can cause a drop in the stock price, and even the investors start to speculate the reasons for the same.
Dividend announced is higher than expected: When such a scenario occurs, the market sentiment of the company will undoubtedly cause an increase in the stock price, and even the investors wonder if the company is seeing substantial growth.
Gains from Dividends
Although dividends from stocks may not result in any real increase in the value for investors when dividends are issued, they do influence the price of any stocks in a way that resembles how cash dividends do. When the declaration of a stock dividend is made, the price rises, and this could have several implications for people who wish to buy a new stock or sell the stock they already own. Nonetheless, due to the fact that a share dividend results in a rise in the number of outstanding shares, while the company’s value stays steady, it is prone to dilute the book value based on a per common stock basis. The stock price may be reduced according to this.
Like the dividends from cash, dividends from smaller stocks tend to be negligible. For instance, a 2% dividend which may be paid for stocks which are trading at Rs.200, only decreases the price to Rs. 196. This could easily be seen as a result of regular trading activity. Nonetheless, a 35% dividend of the stock, dropping the price to Rs. 148, on a per share basis, is not easy to miss.
Now that you, as an investor, know the effect of dividend on stock prices, it is time you invest in the right stocks to earn smartly.
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