Dividends offer gratifying returns on investment. Every quarter, half-year, or year, investors enjoy dividends in the form of cash or additional stock shares from companies that pay them out.

While it’s always nice to receive this form of passive compensation, investors may wonder about the dividend effect on stock price. Does a cash payout drive the price higher? Does stock price go down after dividends are paid? What about dividends paid out in stock shares?

Today, we’ll explore how dividends affect stock prices. We’ll examine the nature and relationship between dividends and stock prices and identify the ways that investors might be able to capitalize at the right time during payout season.

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How Do Dividends Work?

Not all companies pay dividends, but those that do are usually extremely attractive to investors. Dividends are a form of passive income that requires nothing but stock ownership.

Dividends are paid out from a company’s retained earnings. Each shareholder gets a certain rate of compensation according to the number of shares they own.

Usually issued quarterly, dividend payouts are basically the company’s “thanks for your support” message to its shareholder base. After all, investors help finance a business’s operations, so dividends are seen as a token of the company’s gratitude. They’re also a tangible way a company can humble-brag about its recent success — a sly PR move.

Since dividends come from a company’s pool of retained earnings, in most cases, only super-successful companies issue them regularly — we’re talking industry titans like Coca-Cola, 3M, Chevron, and Phillip Morris, along with some companies that aren’t household names but earn consistent profits year after year.

You won’t see small or new companies issue dividends. Even some mega-profitable giants like Amazon still don’t pay them out.

Dividends can be paid out in two forms: cash or added stock shares. Cash payouts are made in percentages of the current stock price — if a company pays out 3% dividends on shares priced at $100 each, every shareholder gets $3 per share they own come dividend time.

With stock dividends, shareholders just get shares (or fractions of shares) in the company added to their brokerage accounts when dividends are paid out.

Using the last example, if a company paid 3% in stock dividend on a share priced $100, every shareholder would get 0.03 in more shares. It’s not a lot for investors with comparatively small stakes, but it is something.

Many companies give investors a choice about how they receive their dividend payouts. Most online brokerages give investors the option to reinvest with additional stock shares rather than having to pay taxes on cash dividends.

But how do dividends affect stock prices? As with many aspects of the stock market, it’s a combination of timing, trading activity, and investor perception.

Declarations, Cash Dividends, and Stock Prices

A deciding factor in the correlation of dividend and stock price is the timing and process of the payout itself.

Before Dividends Are Distributed

Well in anticipation of the dividend payout, the company must make a declaration of how much they’ll pay and the date they’ll pay it. At that time, they’ll usually give shareholders a deadline: the last day investors can buy shares to get their hands on the next payout.

This deadline is called the “ex-dividend date” or just the “ex-date.” It can vary, but the ex-dividend date usually falls one day before the company reviews its stockholder list, also known as the “date of record.”

Suppose that a company announces on July 16 that they’ll be paying out its next round of dividends on August 7 and that the last date investors can buy in to take advantage of this payout — the ex-dividend date — is August 2.

What happens on July 16? Investors know that there’s a dividend opportunity coming up, and they have until August 2 to buy shares to get that dividend, so they buy shares in the company at an increasing clip.

They know if they buy shares in time they’re guaranteed a dividend payout, so they do so in greater numbers — which causes the share’s price to go up.

Oftentimes, in the days just ahead of a company’s ex-date, you’ll see it selling at share prices that are higher than usual. The share price increase is roughly equal to the dividend rate to be paid out, though that hinges on market volume, so it is not a standard figure.

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On the Ex-Dividend Date

What happens to the stock share when the ex-date arrives? It depends.

In all likelihood, investors’ interest in the dividend-paying stock will take a big hit after ex-date. They know that buying shares now won’t get them that immediate dividend payout that’s coming up shortly, so why bother paying the premium to get those shares now? They might as well wait until the dividend after this next one. In this case, share sales decrease and the share price goes down along with them.

But then again, it might go up. If a dividend company’s stock performs extremely well in the days leading to the ex-date, it could elevate beliefs of the stock’s value among analysts and industry watchers. Trading volume could increase dramatically, and it could boost the share price to points beyond the expected dividend amount.

After ex-date, the share price will probably go down again. But if it got high between the announcement and the ex-date, the result might be a net gain in value. The reduction after ex-date may be so small that nobody notices it in the context of a standard business day at the stock market.

As you might expect, some traders live for this time of the quarter, timing the market to capitalize on the dividend calendar. They’ll buy shares before the ex-date and sell them right after the date of record — remember, that’s the date companies finalize who’ll be getting the dividend payouts.

A trader who sells after the date of record collects the dividends and whatever they get for their just-traded shares.

The Stock Dividend Effect on Stock Prices

Do dividends affect stock prices when they’re issued as company shares rather than cash? Yes, but in a different way.

When a company announces stock dividends on declaration day, the share price typically goes up a little bit. But they’re also indirectly announcing the formation of more outstanding shares — they’re creating more shares to give to their investors. As a result, the book value per share gets a little diluted, so the stock price then goes down.

The Dividend Rate’s Effect on Share Prices

Another aspect to consider is how much a company pays out in dividends, whether they do so in cash or shares. Intentionally or otherwise, it can send a concerning message about a company’s prospects.

Most stock dividend rates, especially for successful mega-companies, are in the single-digit range. That’s because payouts are coming straight from the company’s retained earnings.

A dividend payout at a rate of 1 to 3 percent probably isn’t going to turn that many heads in the marketplace.

But what if the stock dividend is, say, upwards of 30 or 40 percent? That causes concern. One of the expectations of a successful company is that it will always reinvest some of its retained earnings back into its business — whether it’s to improve operations or fuel growth.

When a company spends so much of its retained earnings on dividend payouts, investors get concerned. Why is so much money going to investors and not toward reinvesting in operations? Is the company not growing anymore? Are they facing some kind of headwind that’s keeping them behind, and is this extreme dividend just covering up trouble from the investors?

This is why companies that offer dividends have to play a careful game with them. It’s also why many companies are still holding out from paying dividends. Nobody’s going to question the health of a company that keeps reinvesting in itself — it just makes good business sense, they believe.

But a company making dividend payouts needs to be disciplined about how they handle them. The market will react to prevailing perceptions about the company, fairly or not. And nothing drives share price movement like market sentiment.

Dividend Indicators You Can Use

To compare the prospects of companies that issue dividends, a few formulas may come in handy.

Dividend Yield

This is simply the annual return a shareholder gets from cash dividends, measured as a return for each dollar invested. It’s fine as a way to compare income among all one’s holdings.

Dividends per Share

This is the same as dividend yield, just expressed in terms of shares rather than cash. It’s the total profit companies pay to investors over a year.

Payout Ratio

This metric is slightly more meaningful since it’s an indicator of how much the company is paying out from its retained earnings. A high payout ratio means the company is not reinvesting in itself at the moment and probably won’t be able to keep that high level up in the future.

A more stable payout ratio compared to other companies in the industry may indicate a more reliable company.

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