Investors earn money from the stock market primarily through capital appreciation and dividends. The former represents an increase in the value of a stock over time, whereas the latter are payments made by a company to its shareholders as a reward for their investment. These dividends significantly impact a company's stock prices and influence trading strategies. Let us understand the effect of dividends on the share price through easy examples.
What is the impact of dividends on share price?
To begin with, let us first understand what dividends are. “Dividends” are a portion of a company's earnings distributed to shareholders. Mostly, they are paid out as:
- Cash
or - Additional shares of stock
Investors must note that companies that are profitable and generate excess cash often pay dividends to reward their shareholders. Now, the effect of dividends on share price is multifaceted. Let us understand the different scenarios:
Stock price increases before the ex-dividend date
- For those who are unaware, the “pre-ex-dividend date” is the period before the ex-dividend date
- Investors who buy shares during this period qualify for the upcoming dividend payout
- This increases the demand for shares in the market as investors often buy shares to receive the dividend
- Increased demand leads to a surge in the stock price
Let us understand this better through a hypothetical example:
The scenario
- ABC Ltd. announces a dividend of Rs. 10 per share
- The ex-dividend date is set for May 25th, 2024
- Before May 25th, investors will be eligible to receive the upcoming dividend
- They view it as an earning opportunity
- Assume that on May 20th, the stock of ABC Ltd. is trading at Rs. 200 per share
The increased demand
- Investors start buying shares of ABC Ltd. before the ex-dividend date (May 25th) to qualify for the dividend payment
- As more investors rush to buy shares, demand increases
The surge in stock price
- Due to the increased demand, the stock price of ABC Ltd. increases
- By May 24th, the stock price increased to Rs. 210 per share.
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Stock price drops on ex-dividend date
- On the ex-dividend date, a stock starts trading without factoring in the value of its upcoming dividend
- Investors who purchase the stock on or after this date will not receive the dividend
- Therefore, it is common for the stock price to decrease by the dividend amount on the ex-dividend date
- That is because the new buyers will not receive the dividend
- The drop in stock price ensures that investors buying shares on or after the ex-dividend date are not overpaying for the stock
- This decrease in the share price is a normal market reaction
- It maintains fairness and efficiency in the market
Let us continue with the above example of ABC Ltd. and see how stock price drops on the ex-dividend date (May 25th).
The scenario
- On May 25th, the stock of ABC Ltd. begins trading without the value of the upcoming dividend payment of Rs. 10 per share
- Investors know that now they will not be eligible to receive the dividend
- Thus, the stock price is adjusted downward to account for the dividend payment
The stock price adjustment
- Since the dividend amount is Rs. 10 per share, the stock price drops by approximately the same amount on the ex-dividend date
- On May 25th, the stock price of ABC Ltd. hovers around Rs. 200 per share [Rs. 210 (trading price on May 24th) - Rs. 10 (dividend payment)]
Company’s financial health
- Regular and increasing dividends often signal a strong financial health of a company
- This boosts investor confidence and leads to a higher stock price
- Conversely, if investors doubt the sustainability of high dividends, it leads to:
- Volatility
or - A decline in the stock price
- Volatility
Special dividends
- Special dividends are one-time payments made by a company to its shareholders
- These dividends are separate from the regular dividend cycle
- Companies issue special dividends when it has:
- Accumulated substantial profits
or - Surplus cash
- Accumulated substantial profits
- These one-time dividends cause significant price adjustments
- For example,
- Say a company announced an unusually large dividend
- As a result, the stock price will drop substantially on the ex-dividend date
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How does a stock dividend impact the share price?
A stock dividend is also known as a bonus issue. It impacts the share price differently from a cash dividend. Let us see how:
- Stock dividends provide existing shareholders with “additional shares” rather than cash
- This increases the total number of outstanding shares in the market
- Now, each existing shareholder owns a smaller percentage of the company
- This dilutes ownership and reduces the earnings per share (EPS)
- Consequently, investors perceive less value for money, which leads to a decrease in the stock price
Let us understand this effect of dividends on share price through a hypothetical example:
The scenario
- Say XYZ Ltd. currently has 1,00,000 outstanding shares
- The current market price of the shares is Rs. 100 per share
- The company announces a bonus issue of 1 new share for every 10 shares held
- This means a total of 10,000 bonus shares will be issued
- This increases the count of total outstanding shares, which now becomes 1,10,000 (1,00,000 existing shares + 10,000 bonus shares)
Impact of dividend on share price
- We know that a company's total earnings are spread across all outstanding shares to calculate EPS
- This issuance of bonus shares increases the total number of shares without changing the earnings
- As a result, the EPS decreases because the same earnings are now distributed among a larger number of shares
- Often, a lower EPS leads to a decrease in the stock price
- That is because investors perceive the company as less profitable on a per-share basis
Conclusion
Dividends represent the earnings of a company divided among its shareholders. The effect of dividends on share prices is multifaceted. Usually, before the ex-dividend date, increased demand from investors willing to qualify for dividends leads to a surge in stock prices. However, on the ex-dividend date, the stock price drops by the dividend amount as new buyers won't receive it. Similarly, when companies announce stock dividends, it leads to a fall in their EPS. Investors often see this decrease in a negative light, leading to a fall in stock prices.
Do you know human emotions play a crucial role in the share market? Study trading psychology in detail and optimise your trading decisions.
