Investing in dividend paying companies is a great way to create long-term wealth. One of the primary reasons is that the stocks of such companies offer a dual benefit to investors by way of both regular dividend payouts as well as share price appreciation.
That said, did you know that the decision by a company to distribute dividends to its equity shareholders is capable of affecting its share prices? Yes, you read that right. There is a correlation between dividends and the share prices of companies. If the question ‘how do dividends affect stock price?’ is running on your mind right now, here’s the answer.
But before we get to the part where we discuss how dividends affect stock prices, let’s quickly take a look at the concept of dividends.
The concept of dividends
The equity shareholders are technically the owners of a company. And as such, they enjoy a claim on the profits of the company. So, when a company generates profits, it distributes it to its equity shareholders by way of dividends.
When it comes to paying dividends, a company need not always pay them out in cash. Companies are also allowed to pay dividends out to its shareholders by way of allotting them fresh equity shares of the company for free. Such a dividend payout is commonly referred to by investors as stock dividends.
Companies don’t make dividend payouts just because of the fact that its equity shareholders have a claim on its profits. It does so as a way to thank its equity shareholders for believing in the company and investing in it. In addition to that, a company also pays dividends to its existing shareholders to encourage further investment from prospective investors.
How does dividend affect share price?
Now that you’re aware of the dividend concept, let’s move on to answering the question ‘how do dividends affect stock price?’ Paying out dividends basically act as a good indicator of the company’s financial health and success. That said, here are some pointers that clearly show how dividends affect stock prices.
Dividend paying companies enjoy favourable treatment
Although equity shareholders enjoy a claim over the profits of the company, they however, lack the right over the distribution of such profits via dividends. In spite of the fact that these shareholders are not guaranteed dividends, many well established companies have made it a habit to regularly and consistently distribute the profits that they generate.
This creates a perception of stability in the financials and enhances the goodwill and brand value of the company. Investors tend to view such entities in a far more favourable manner than other entities that don’t distribute dividends as often. This consistent dividend paying mechanism of such companies tends to attract even more investors, thereby creating demand for the stock. As more and more investors flock towards the company, the share price witnesses an increase.
However, there’s another side to this coin. A company that pays dividends irregularly or at a rate that’s lower than usual tends to attract negative public sentiment. This is because investors view such companies as being financially volatile, thereby putting off the entry of new investors and causing the exit of some existing shareholders. The share prices of such companies usually take a hit and can slide down. This effect can sometimes be more pronounced in companies that had a previously great track record of paying dividends consistently.
Dividend declaration leads to an increase in the share price
A company, before distributing the dividend out to its shareholders, first makes a public declaration. This declaration includes essential details such as the dividend amount, the record date, the ex dividend date, and the date on which the dividend is likely to get credited to all the equity shareholders of the company.
Such a public declaration has the effect of increasing the public sentiment for the company’s stock in a positive manner. This would inevitably lead to more investors purchasing the stock, thereby leading to an increase in the share price. In addition to this, many traders and investors may also buy the stock of the company for the short-term in order to be able to capture the dividend issued by the company. Such a move would also work towards increasing the price of the dividend issuing company’s stock.
The share price drops down on the ex dividend date
Continuing on from the previous point, the share price that rose when the company declared the dividend would automatically correct itself on the ex dividend date. This is primarily because of the fact that any new buyers of the company’s stock on or after the ex dividend date would automatically become ineligible for receiving dividends.
And since the new buyers would not be getting any dividend benefit by purchasing the company’s shares, they would generally be unwilling to pay a huge premium for the shares. Since the buyers would start quoting lower prices for the shares of the company, the sellers would be forced to drop their asking price as well, leading to a drop in the company’s stock price.
The above three pointers answering the question ‘how does dividend affect share price?’ are not only applicable to companies that pay out dividends in cash, but also to companies that distribute dividends through stock issuances. That said, there’s also the concept of ‘dividend payout ratio’ that has the potential to affect the share prices of dividend paying companies. For instance, if a company’s dividend payout ratio (DPR) is too high, the chances of sustaining consistent dividend payouts become low since the company is paying out high dividends. This can end up working against the company as it creates a negative sentiment on the stock, thereby lowering the share price.
On a similar note, a low dividend payout ratio essentially means that the company is paying out too little dividends. Again, this can also negatively affect the share price of a stock. Only companies that have a stable and moderate dividend payout ratios get to enjoy positive investor sentiment and higher share prices.