How does a dividend affect a share price? This is an important topic for any trader and definitely something you should be considering before placing any trade – both in general and in relation to the timing of the specific stock you are interested in trading. I’m going to talk about what a dividend is, how this affects the price of a stock and how you can prepare for these fluctuations as a trader.
We want to answer, “How can a dividend affect a share price”, but first of all, what is a ‘dividend’?
So…. back to companies 101…. we know that a company is a business (or it can be an investment vehicle) in a legal entity ‘wrapper’. It is treated as a separate person entirely, from the business owner(s). The business is split into portions like dividing up a pie and these portions are the ‘shareholdings’ of the company. So the people who own the business are the ‘shareholders’ and they each own a piece of the company in accordance with their share holding and certificate, like a slice of pie. A dividend is a mechanism by which, the business pays out some profit to its shareholders.
So how do dividends come about?
In order to determine an answer to the question, how does a dividend affect a share price, we must first also understand how dividends come about! Any assets or income belongs to the legal entity of the business and is received within the legal entity. In order to distribute some of this income to the owners of the business (the shareholders), a ‘dividend’ must be declared and paid. The business will declare a dividend from ‘distributable profits’ only. If they do not ensure the dividend is made from ‘distributable profits’ it is possible the dividend will be made illegally. This is a slightly different topic but the directors basically need to ensure that the business has got enough cash and spare money before paying the shareholders a dividend, to make sure it is being fair to its creditors. The worst case scenario which could occur is that the company could pay a dividend and it depletes funds needed to pay creditor liabilities – this is why they must be paid from ‘distributable’ reserves. This is a slight digression, but it was worth noting here for anyone who does not know much about companies and how they work.
OK, so back to where we were… the directors of the company will assess whether the company is in a position to pay a dividend, and they will ‘declare’ it / in other words, they will announce to the market, that they have decided a dividend will be paid. This is the ‘ex dividend’ date – which is important. The cash payment of the dividend will follow a little while later and will be paid to the share holders in accordance with their slice of pie share holding. So if the company is divided up into 10 slices of pie (shareholdings) and they are all equal shareholdings, and the company declares a dividend of £800, what this means is that each slice of the pie shareholding will receive £80 as a dividend.
Are dividends mandatory?
No – dividends are not a mandatory thing on the part of the directors. They need the freedom and discretion to be able to examine the company’s financial position, prior to making any dividend declaration, and consider whether the company can afford to make a dividend from its distributable reserves.
Not only this, but some companies do not usually pay dividends and other ones do. It is entirely in the discretion of the directors and they are usually following the particular customs of the company in question. If a company usually pays a 1% dividend to shareholders, the shareholders would be in a position where they are accustomed to receiving this, and they would expect it. Indeed, it may be the reason they purchased those shares – some shareholders just purchase shares for the purposes of receiving dividends, and some shares pay more dividends, and pay more ‘often’ than others – so if the investor is someone who is interested in receiving dividends as income rather than more capital growth from his/her shareholdings, they may tailor their investment portfolio to the companies which pay dividends regularly and at a good rate. Notwithstanding this, the discretion of the directors must always be applied to ensure the dividends are not made illegally (from non distributable reserves – depleting funds for the creditors).
So how does a dividend affect a share price then?
So when a company makes a dividend, this dividend is in effect, the company paying out some of it’s earned profits to the shareholders. The company’s worth (share price) is based on it’s assets and earnings potential – it’s an estimate by the market based on supply and demand, of what people think that is worth! So when the company pays out some of it’s worth as a dividend, it is literally depleting the balance sheet of reserves and profit/cash – which could be used to buffer the company from any troubles, buy more assets, grow the business etc. I’m not saying paying a dividend is a bad thing but it ‘must’ affect the share price – logically, it will.
So when the stock goes ‘ex dividend’ (when the dividend announcement has been made), you can expect the stock to take a temporary nose dive in terms of the share price.
How can you plan your trades around this?
Make sure before you open a position on an equity, that you know what the next ex dividend date is, and be prepared in the plan of where to enter and exit, for the drop in share price when the stock goes ex dividend. If you are confident that there will be no significant impact from the question, how does a dividend affect a share price that’s fine… but it could affect your win rate if you ignore this and get in anyway!
I hope you found this article informative on resolving the question, how does a dividend affect a share price. Perhaps if you did, you can leave a comment below!
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