Dividend history often finds a spot in every seasoned investor’s checklist while investing in stocks. Though dividend distribution is purely an optional financial decision of companies, it has a lot more to do with the share price than you might think. Market participants must have observed stock prices taking dividend announcements positively and slumping when the stock goes ex-dividend.
Still, the question that remains is how do dividends affect stock prices? We’ll look to answer that, but before that, let’s know what a dividend is.
What are dividends and what is their significance?
Dividends are rewards given to shareholders for contributing to the equity of a company. In simple terms, it is the share of profit that is distributed among the shareholders. Companies use dividends to distribute profits to their shareholders as payback to show faith in the company and encourage them to maintain their trust. Dividends themselves are a valuable addition to the company’s image because it is perceived that only those companies with a consistent track record of cultivating profits distribute dividends. That said, companies are in no way bound by any law or regulation to pay out or not pay out dividends; they have the right to either distribute their profits as dividends or reinvest them in the growth of the company.
To get an insight into whether a company is in a position to pay a dividend or not, it is important to understand a company’s financial statements. To know more, read our article on how to read a company balance sheet before buying a stock on Teji Mandi blogs.
For investors, dividend-paying stocks are always prized possessions. Because apart from the potential value appreciation, a shareholder also receives a recurring income from the company in the form of dividends. It’s usually distributed in cash, but sometimes companies offer additional shares to shareholders as dividends.
Some investors even keep track of companies that pay decent and consistent dividends and use what is called a Dividend Strategy for investing. Between the date of dividend announcement and distribution, the stock prices generally undergo some erratic movements. Let us see how dividends affect stock prices.
Ways in which dividend affects stock prices
Investors mark their calendars for dividend notifications coming from companies having a track record of paying handsome dividends. While stock price follows a predictable pattern most of the time, you can never convincingly predict how a stock would actually react to the dividend announcement.
1. Investors prefer dividend-paying companies
Traditionally there’s been an inclination of investors towards dividend-paying counters. If I ask you to pick one of the following, what would you choose – A stock that promises decent upside potential or a stock that promises decent upside potential along with a decent dividend payout?
Obviously, a prudent person will be inclined towards dividend-paying stocks.
Companies with a stable dividend payout history are financially sound because the dividend represents a part of the company’s profits and thus is preferred for long-term investments.
Many reputed companies have made it a habit to pay out consistent dividends despite no legal liability. This further reinforces shareholders’ beliefs in the company and adds to its goodwill.
However, there’s a flip side to the coin; companies with irregular or declining dividend payout trends act as a red flag for the company because investors always feel safe with stocks that show stability.
Uncertainty is not liked by market participants and thus works negatively for the company.
Dividend becomes a major factor for some investors while they are looking for shares to invest in. Experts at Teji Mandi filter out stocks that best suit your financial goals and needs, as well as your risk appetite. For active advice, download the Teji Mandi app!
2. Dividend Rally
Dividend distribution is not a surprise event, and companies make a public announcement well in advance of the dividend distribution date. This announcement contains details like dividend payout ratio, amount of dividend, the record date for the dividend, the date on which the share will become ex-dividend, and the actual payout date when cash is distributed to the shareholders.
Dividend announcements create positive hype around the stock as investors look to reap short-term gains by owning the stock before the ex-dividend date. As a result of this strong demand, the stock price shoots upwards. Buyers are willing to pay a premium price because they know they’ll receive a dividend.
Swing traders buy shares of companies where a dividend is announced or is going to be announced and enjoy the profits of the dividend rally by selling the shares as soon as the share goes ex-dividend.
Some examples of dividend rallies include:
- Vedanta, a listed company, announced a massive interim dividend of 1300% on the face value of the share( Rs 13 per share), and the stock rose 1.6% on the day of the announcement.
- In 2021, BPCL, another company famous for distributing attractive dividends, came up with Rs. 58 dividend per share. On the date of the announcement, the share price climbed 2.5%.
Before discussing this, we should understand the significance of the ex-dividend date. The ex-div date refers to the record day on which companies decide the eligible shareholders for dividend payment.
Buyers who have purchased the shares before the ex-dividend date are eligible for the dividend, and those buying the shares on or after the ex-dividend date are considered ineligible.
Since on and after the ex-dividend date, the dividend is not on offer, buyers may not be interested in paying the premium price of the share. When buyers show little interest in the current market price of the shares and bid lower prices, sellers are automatically forced to bring down their ask prices, resulting in selling pressure on the stock.
Moreover, buyers who have purchased the shares purely for earning the dividend start selling the shares as soon as the stock goes ex-dividend. Even though they sell the shares after the ex-dividend date, they’ll still be eligible to receive dividends.
The general trend has been that the share prices fall when the share becomes ex-dividend is pretty much the dividend payout – the dividend price gets roughly adjusted from the share price.
For instance, in the above case of BPCL, where the company issued a dividend of Rs. 58 per share, the ex-dividend date was set for 16 Sep 2021. In the subsequent 4 trading sessions, the stock experienced what we call “Dividend adjustment”; it fell from its high of Rs. 495 registered on 15 Sep 2021 to Rs. 413. This selling could be mainly linked to buyers who exited the share on the ex-dividend date.
4. Stock dividends
Companies have the choice to distribute proportionate fresh shares to shareholders as a dividend; this is called the stock dividend. The stock dividend provides value for shareholders in the form of additional shares.
But the fact that the company’s value remains the same and only the number of outstanding shares is increased, the share prices tend to fall. Stock dividends dilute the shareholding further, reducing the book value per share but keeping the overall value of the company the same. This may also bring a decline in the share price. Stock dividends are an infrequent sight, as companies usually pay dividends out of their accumulated profits.
Let’s take a scenario to understand the effect of stock dividends on share prices.
Suppose a company with 1,00,000 outstanding shares has a current market price of Rs 250 for each share. The total market cap of the comes to be Rs. 2,50,00,000 (1,00,000 shares x Rs. 250 per share).
Now, the company announces stocks as dividends in the ratio of 1:10, i.e., one new share will be issued as a dividend for every ten shares held by investors.
Since the company’s value is the same, i.e. Rs. 2,50,00,000, and the number of shares has increased, the result will be in the form of a decline in the book value per share.
5. Market expectations of dividend
The stock market speculates a lot of things, and when things don’t churn out according to speculations, the markets move erratically.
The same applies to dividends also; how a dividend will affect the share price fairly depends on speculations going around the dividend to be announced.
There can be two possible scenarios:
- The dividend announcement is at a higher rate than what was speculated, the market sentiment shifts to strong bullish, and the share price is expected to rise.
- The dividend announcement is lower than what was speculated by market participants; the share price starts to fall at the time of the announcement itself. Generally, we see stock prices increase when a dividend is announced and start falling when the stock becomes ex-dividend. But in cases where dividend announcement is below the market expectations, the price begins to fall as market participants try to figure out the reason for the same.
Conclusion
Now that you know how dividends affect share prices and bring about a rise or fall in it, you can invest in dividend-paying stocks for earning dividends. You can also work smartly and invest in stocks only to take dividends and exit them when they become ex-dividend if you want to follow a dividend investing strategy for your portfolio. The general market behaviour on dividends includes an increase in the share’s price near the date of dividend announcement and a decline once the share becomes ex-dividend. However, there’s no hard and fast rule that the same has to be followed every time.
As investors, companies with stable, consistent dividend payouts may be considered as value-adds to the portfolio to build passive income over the long term.
To get to know the latest updates regarding dividend announcements, price fluctuation, and when and where to invest, you can rely on the experts at Teji Mandi. Reach out to us on our website for more details!
