How Dividends Affect Stock Price

How Dividends Affect Stock Price

If your investing strategy is based around income generation, you may tend to favor companies that issue dividends. And why wouldn’t you like a little extra payout now and then? But, before you pick your investments, it’s important to understand how dividends fit into your portfolio and why they matter to the market.

When it comes to investors interested in dividends, the shared question we hear most frequently is, “How do dividends affect stock price?” To understand the answer, it’s important to know the difference between expected and unexpected price changes.

How Dividends Affect Stock Price

When a company goes through the process of issuing a dividend, the company’s stock price can potentially be impacted in two different ways:

  1. If the company declares a dividend payment that’s higher or lower than expected, market sentiment may shift causing the stock price to rise or drop accordingly.
  2. An expected change in price occurs on the ex-dividend date when the company decreases its market cap by the declared shareholder payout.

Price Changes on Declaration Day

When a company declares a dividend amount that’s higher or lower than expected, the company’s stock price can fluctuate in response to the declaration. Let’s consider two examples.

Example 1: A Lower-than-Expected Dividend is Announced

Let’s say company XYZ typically pays a dividend of $0.50 per share and has stuck to that amount for the last 5 years. Then, XYZ declares a dividend amount of only $0.04 per share.

In this case, the market sentiment around company XYZ may cause its stock price to drop as investors speculate as to the reasons why the dividend amount was lower than normal.

Example 2: A Higher-than-Expected Dividend is Announced

Sticking with the same hypothetical company, let’s say XYZ just announced a dividend of $0.60 per share – up 10 cents from previous dividend payments. In this case, market sentiment around the company may cause a rise in stock price as investors wonder if the company is exhibiting more growth.

Price Changes on the Ex-Dividend Date

When a company issues a dividend, the cash that makes up the dividend payment no longer belongs to the company. Because this is transferred to shareholders, the company’s share price is reduced by the amount of the dividend payment on the ex-dividend date.

For stocks with small dividend payments, you may not even notice the decrease; one or two cents per share may look like normal trading activity. Bigger dividend payouts, however, can be more noticeable. In 2004, the share price of one stock dropped by more than $2.00 per share when a company paid out dividends.

What an Expected Decrease in Stock Price Means for You

A decreased stock price could mean different things for you depending on how you use your dividend payout.

If you reinvest…

Let’s say you have $1,000 invested in XYZ at $10 per share. Then, XYZ decides to issue a dividend payment of $2.00 per share. After the dividend is paid, you have $800 invested in XYZ and $200 in cash. If you reinvest your $200, you’d still have $1,000 invested in XYZ but you’d own more shares in the company – because your $200 is buying shares at $8 instead of $10 – which could work to your advantage if the stock price increases.

If you treat the dividend as income…

If you didn’t reinvest your dividend payout into XYZ, you’d still own the same number of shares (and be eligible for the same amount of future gains or losses the company experiences) but now you’d have an extra $200 in your bank account.

How Future Trades are Impacted

Using the same example of XYZ, let’s say you had a stop-on-quote order set to sell your shares of XYZ if the price dropped below $9 per share. But, when the dividend payout caused the stock price to drop to $8 per share, your order didn’t execute. What happened?

When a company issues a dividend payment, the order routing exchanges automatically adjust any outstanding limit prices accordingly. So, when the share price of XYZ was reduced by $2 per share, your stop price would have been reduced by the same amount from $9 to $7.

So, now that we’ve covered why dividends and share price matter to your portfolio, why do they matter to the market?

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