Investors have various ways of evaluating the success of a company and comparing various entities with the intent of creating a profitable portfolio. One of the applicable strategies involves dividends. Notably, the connection between dividends and a firm’s share price revolves around the broad concept of dividend psychology. The way that investors react before, during, and after the declaration of dividends tends to impact the price of a stock.
What are dividends
Dividends refer to the funds that a company distributes to its shareholders from its retained earnings and the generated profits. This means that for a firm to offer dividends to its shareholders, it has to be profitable. Indeed, in addition to being a way to thank the investors for supporting the company, it is a measure of success for the firm in question.
The company can distribute the funds annually, semi-annually, quarterly, or monthly. Besides, depending on its profitability and expansion objectives, it may not necessarily avail dividends steadily.
It is also important to note that the amount one receives as dividends depends on the owned shares. For instance, if a company declares that it will issue a 50-cents dividend, an investor with 50 shares will receive $25. In comparison, the one with 1000 shares is entitled to $500.
The figure, which is usually in the form of a percentage, is a dividend-to-price ratio that shows the amount that a firm will distribute to its shareholders as dividends per annum. It is relative to the share price. This means that if the dividends are not hiked or cut, a decline in the stock price will result in a rise in dividend yield.
A company that is subject to heightened growth may have low a low dividend yield. In comparison, a well-established company that is not growing as fast has a relatively high dividend yield.
Dividend payout ratio
This is the percentage of a company’s earnings that is paid out to its shareholders in the form of dividends. To compute this figure one needs to divide the annualized dividend per share by EPS (earnings per share). For investors keen on dividend-yielding stocks, a high dividend payout ratio is a positive signal.
Dividend vs. Share repurchases
Share repurchases and dividend payments are two of the main ways that companies share their profits with the shareholders. On the one hand, dividends refer to the firm’s profits distributed to the stockholders after taxes. On the other hand, share repurchases involve the buying back of a company’s stocks from its shareholders with the intent of reducing the number of outstanding shares.
In addition to transferring the amount on its balance sheet to its shareholders, share repurchases is an approach used when a company’s stock becomes undervalued. To get investors to participate in the buyback, the firm will provide a premium to the market price. With the resultant decline in the outstanding shares, the stock price will likely rise.
How dividends affect share price
Now that we have a better understanding of how dividends work and the key related terms, it is now easier to understand how dividends affect the price of a company’s shares. Notably, the existing connection between dividends and stock price is largely founded on the concept of dividend psychology.
Dividend psychology revolves around three crucial dates. This includes:
It refers to the day when the firm’s management or board of directors announces that the shareholders will receive dividends.
Even is the company has a history of paying dividends, it is not guaranteed until the management announces it on the declaration date. Indeed, it is possible for a dividend-paying firm to skip a payment depending on the attained profits and/or its intentions to expand. On the declaration date, the board also bears the mandate to stipulate the ex-dividend and payment dates.
This is usually one business day prior to the date of record when the firm checks its records to identify the stockholders that will receive the dividends. For one to get the dividends, they must own the stock by the ex-dividend date.
Buying the stock on or after this date means that you won’t receive the dividend payment. On the other hand, you will still get the dividends if you choose to sell the stocks on or after the ex-dividend date.
It is the day that you actually receive the cash. For those who bought the company’s shares via a broker, the dividends are sent to the broker, who then deposits them into their account.
Now that we understand the key concepts associated with dividends, it is easy to comprehend how dividends affect a company’s stock price.
A company’s stock market price tends to rise prior to the dividend declaration period. This is due to the fact that some investors tend to purchase stocks before the dividend declaration date, which occurs one business day prior to the ex-dividend date. As aforementioned, one receives dividend payments for as long as one’s own the shares prior to this date. As is the case with other financial assets, the presence of more buyers tends to boost the share price.
Interestingly, it drops immediately after the distribution of the dividends. This is largely because the payments made per share are deducted from the stock’s value. Besides, buyers on or after the ex-dividend date are not eligible for the dividend payments. As such, they are unwilling to pay a premium for the stocks.
As aforementioned, the dividend yield shows the amount that a company will avail in the form of dividends relative to the share price. In an effort to diversify their portfolio, some investors are keen on companies with a high dividend yield.
This strategy requires one to identify firms with a steady record of paying significant dividends. This also involves evaluating its financial capability to maintain high yields. From this perspective, a company with a track record of rising dividend yields is likely to attract more investors, thus, boosting its stock market price.
Dividends cuts & hikes
Seeing that dividend payments depend on the company’s profits, a decline or increase in the announced amount often impacts the share price. For instance, higher-than-expected dividends can be a sign of steady cash flows. Such a healthy performance tends to attract investors and subsequently increase the firm’s share price.
Even so, it may also signal a reduction in the opportunities for growth and expansion. If that’s the case, investors may be less confident about its future, which will translate into a decline in the stock price. The model is also viable in the case of dividend cuts.
Dividends are one of the aspects that one can use to select the stocks worth investing in. It is important to note that dividend cuts and hikes are not only found in the profitability of a company, but also in its long-term vision and growth opportunities.