How do Dividends Affect a Trading Position?
High-dividend stocks are very popular among investors who’re looking for regular income. When companies pay dividends, they share the wealth to the company’s investors – the shareholders – by distributing a portion of the company’s earnings.
However, investors who are looking to build a predictable annuity-like cash stream need also to be aware of how dividends can affect a trading position and the underlying stock’s price.
Read this overview of what dividends are and how they affect the stock price from the time a company announces dividends to the time they’re paid.
What Are Dividends?
Dividends are a popular source of investment income for investors. The company that issues dividends uses them as a way to redistribute profits to shareholders, but also as a powerful channel to signal the company’s financial stability and success. Only highly profitable companies can pay dividends on a consistent basis, making them a popular choice for buy-and-hold investors, but also shorter-term traders.
Since dividends are paid from a company’s retained earnings, companies that consistently pay dividends are very popular among investors. Those companies are also considered financially stable, increasing the desire of investors to hold stocks of such companies.
While this usually leads to higher stock prices, companies that pay dividends need to be cautious in the long run: If a company that has traditionally paid dividends each year decides to skip its dividend payments, this could be interpreted as a sign of weakness and decreasing profits by investors and lead to a fall in the stock’s price.
Stock Dividends vs Cash Dividends
Dividends are paid either in cash or in the form of additional shares. For example, if a company declares a dividend of $0.40, this means that an investor who holds 100 shares will receive $40 of dividend payments.
Similarly, if a company decides to pay stock dividends of 10%, the same investor who owns 100 shares will receive an additional 10 shares as a form of dividend payment. In either way, the dividends will make the shares of the company more attractive as the dividend payout date approaches and lead to a rise in the stock’s price.
Nevertheless, since cash dividends reduce the amount of retained earnings in a company, investors may start to question the company’s ability to invest in new technology or important future projects. That’s another reason for companies to be cautious when declaring dividend payments: High dividends can both attract new investors but also scare the market as the company’s future financial stability gets questioned.
In the case of stock dividends, the total number of shares outstanding increases while the total value of the company remains stable. This means that stock dividends dilute the company’s book value per share, leading to a fall in the stock’s price after existing investors receive their stock dividends.
Read: How to Choose the Right Share Trading School
How do Dividends Affect Stock Prices?
Companies that want to pay dividends need to declare the dividend amount and the payment date. At the same time, companies also announce the date at which existing investors are eligible to receive the dividend payments, called the ex-dividend date.
The ex-dividend date is usually set one business day before the company reviews its list of shareholders, called the date of record. After a company announces dividend payments, the company’s stocks will become more attractive to investors. Investors are willing to pay a premium for owning the stock since they know that they’ll receive dividends after the ex-dividend date.
This premium gets incorporated in the stock’s price, which means that the price usually rises by the amount of the dividend after a company declares the dividend amount and the payment date. In some cases, when investors feel very optimistic about a company, the stock’s price may rise even more than the dividend as demand for the stock increases.
After existing investors receive their dividends, new investors are not willing to pay a premium for holding the stock anymore. As a result, the stock’s price usually falls by the amount of dividend on the ex-dividend date.
However, the drop in price can sometimes be smaller than the dividend payment, especially if investors anticipate a bright future and increased future earnings for the company. Similarly, if the dividend payments are relatively small compared to the current stock price, the drop in the stock’s price on the ex-dividend date may even go unnoticed.
How to Analyse Dividends?
There are many ways to analyse dividends and their effect on stock prices. Some of the most popular measures include:
- Dividends per Share (DPS)
- Dividend Yield
- Dividend Payout Ratio (DPR.)
Dividends per Share
The Dividends per Share ratio, also known as DPS, is a ratio that measures the total amount of a company’s profits that are paid out in the form of dividends. DPS is expressed as per share and is calculated by dividing the sum of all dividends over a year by the number of outstanding shares. Investors usually subtract the amount of special dividends from the sum of all dividends when calculating the DPS for a company.
DPS can also be used in combination with the payout ratio to analyse the sustainability of a company’s dividend payments. Let’s say that company XY has an EPS (earnings per share) of $0.40 but a DPS of $0.50. The payout ratio would be 125% (0.50 / 0.40), which means that the company pays out more dividends than the amount it’s earning, making the current dividends unsustainable over the long run.
Dividend Yield
The dividend yield refers to the annual return that an investor earns from cash dividends per share. It’s calculated by dividing the annual dividends per share by the current price per share.
The dividend yield of an investment is a basic measure that helps investors to quickly compare different investment options based on the expected annual dividend yield.
However, bear in mind that this measure has its limits: For example, imagine that a company is facing financial problems and see its stock price fall as a result. While this would increase the dividend yield, the annual return from dividends could be offset by a falling stock price.
Dividend Payout Ratio
To avoid the limitations of the dividend yield measure, investors can use the Dividend Payout Ratio or DPR. This measure is calculated by dividing a company’s total dividend payments with its net income and is expressed as a percentage.
If the DPR is relatively high, it may signal that the current dividend payments relative to the company’s net income could be too high and unsustainable in the future. Investors often compare the DPRs of different companies in the same industry to determine in what company to invest in.
Final Words
Companies pay dividends to distribute their earnings to the investors of the company – the shareholders. While they’re often paid in cash, a company can also decide to distribute stock dividends. Dividends are paid annually or quarterly by companies with strong financial standings and profitable business models.
Dividends can directly affect the underlying stock’s price and a trader’s position. When a company declares that it will pay dividends, the stock price usually rises as investors become willing to pay a premium for the stock.
On the ex-dividend date, the stock’s price usually falls as new investors aren’t willing to pay a premium since they aren’t eligible to receive dividends anymore.
