Investing in shares of companies that pay dividends regularly is one of the most prudent and efficient ways of making money in the markets. On the one hand, the cash received as dividend from a company provides more money to a shareholder. On the other hand, capital appreciation on account of rising share prices rewards the shareholder in the long term. In the context of these facts, a natural question may occur in investors’ minds is: Is there a relationship between dividends and the share price of a company? The answer is a resounding ‘Yes’. Before we get into how dividends impact stock prices, let us take a quick view of what dividends are:
Dividends are cash payouts to shareholders. Usually, the dividend amount paid is a fraction of the profits made by a company. The board of directors of a company decides to pay a dividend to shareholders. Shareholders have no control over the timing and quantum of dividends to be paid.
Now, let us understand how dividends impact the share price of companies.
Rising stock prices
Investors generally prefer to reduce uncertainty while investing in the stock market, which is fraught with many risks. A company that pays regular dividends demonstrates its ability to generate regular cash. No wonder, more investors prefer to buy shares of such companies. Either they can use the cash received as dividend to pay for their needs or they can use it to reinvest. Shares of such companies generally enjoy better valuations than their peers who do not pay dividends.
This effect on share prices can be seen in the long term. Dividends also impact share prices in the short term as well. Here is how it works:
Dividend rush
A large number of investors keenly observe the time at which companies announce dividends. When a company announces about its plans to give dividends, investors who are keen on pocketing dividends start buying the shares of such a company. As a result of this, share prices of companies go up. If a company announces a dividend that is in line with or more than market estimates, then the share price keeps rising as more and more investors want to own the stock with an intention to pocket a dividend. If the quantum of the dividend announced is less than market expectations, then the price of the share tends to go down.
If a company has received substantial cash due to the sale of a business or because of some other reason, then many investors anticipate distribution of such cash by way of a special dividend payout. In that case too, share prices go up. This alertness towards dividends announcements pushes up stock prices in the short term.
Going Ex-dividend
An investor who holds a stock on the record date of a dividend gets paid the amount of dividend by the company. There is always time between dividend declaration date, record date and dividend payout date. Record date is a date on which shareholders holding shares are eligible to receive dividends. When companies announce their plans to give dividends, investors who are keen on pocketing dividends start buying shares of such companies.
Generally a stock goes ex-dividend a day before the record date. One who buys shares on the ex-dividend date or later is not eligible to receive dividends. Hence, the share price adjusts to the extent of dividend payout per share. For example, if a share is trading at ₹300 and the dividend payout in question is ₹10, then on the ex-dividend date, the share price should adjust to ₹290.
Dividend yield
Among various valuation tools used by analysts to arrive at the fair price of shares, dividend yield is used by many conservative investors. Dividend yield is calculated by dividing the dividend per share by the price of a share. For example, if the dividend paid is ₹10 per share and the price of the share is ₹300, then the dividend yield works out to 3.33%
Other things being the same, higher the dividend yield better is the stock. When markets are in a bear phase, stocks with high dividend yield tend to fall less. If the price falls, then the dividend yield goes up and this makes a stock even more attractive. Stocks of high dividend-paying companies quoting at a decent dividend yield rarely get trampled by investors in a bear market.
These facts establish that there is a correlation between dividends and the share price of a company. Though dividends impact share prices both in the long and short term, savvy investors seldom rely solely on dividend payouts of a company. They evaluate the dividend payout ratio of a company in conjunction with the rate of growth of its profits and its overall financial health before investing.