Dividends —part of a company’s earnings distributed to shareholders—play a pivotal role, not only as a source of income but also as a key influencer of stock prices. In this post, we’ll learn how they work as well as their impact on the underlying stock’s price.
How Dividends Work
Dividends are a way for companies to distribute a portion of their earnings back to shareholders, essentially rewarding them for their investment. They represent a significant source of income for many investors and can greatly influence investment strategies.
Declaration of Dividends
The process begins with a company’s board of directors declaring a dividend. This announcement sets the dividend’s size and establishes important dates known as the declaration date, the ex-dividend date, the record date, and the payment date.
Important Dates to Remember
- The declaration date is the day the board of directors announces the dividend. The dividend announcement typically includes the size of the dividend, the record date, and the payment date.
- The record date is the cut-off date established by the company to determine which shareholders are eligible to receive the dividend.
- The ex-dividend date, typically set for two business days before the record date, is the date by which a purchase of the stock will not entitle the new owner to the upcoming dividend.
- The payment date is the day the dividends are actually distributed to shareholders.
Types of Dividends
Dividends generally come in two forms: cash dividends and stock dividends.
- Cash dividends are the most common type. A company pays out a portion of its profits to shareholders in the form of cash. The cash dividend is typically sent via check or directly deposited into the shareholder’s brokerage account.
- Stock dividends involve the company issuing additional shares to existing shareholders in proportion to the number of shares they already own. Stock dividends effectively allow shareholders to maintain their proportional ownership in the company while the company conserves its cash.
Dividend Payout and Frequency
The amount a company pays as dividends is decided by the board of directors and is usually expressed as a certain amount per share. For instance, if a company declares a dividend of $1 per share, an investor holding 100 shares would receive $100.
Most U.S. companies pay dividends quarterly, while others may pay them monthly, semi-annually, or annually. Some companies even issue what is known as a special dividend, which is a one-time distribution of cash to shareholders over and above the regular dividends.
Tax Implications of Dividends
Dividends are generally taxable to the shareholder in the year they are received. However, the tax rate can vary depending on whether the dividends are qualified or non-qualified. Qualified dividends, which meet certain criteria set by the IRS, are taxed at long-term capital gains rates, which are generally more favorable than ordinary income tax rates.
How Dividends Influence Stock Prices
To delve deeper into understanding how dividends affect stock prices, we first need to understand the primary relationship between a company and its shareholders. When you buy a company’s stock, you’re essentially purchasing a small piece of that company, entitling you to a share of its profits. One of the ways these profits are distributed is in the form of dividends.
Now, let’s dissect how dividends can influence stock prices:
The Dividend Announcement Effect
When a company announces that it will be issuing dividends, this news can impact the stock price. This is because dividends are a sign of a company’s profitability and financial health, indicating to investors that the company is performing well. Therefore, the announcement of a dividend often leads to increased demand for the stock, driving its price up.
Let’s consider the case of Microsoft. In September 2021, when the tech giant declared a dividend increase of approximately 10%, its stock price saw a corresponding increase as the market reacted positively to this news.
The Ex-Dividend Date Effect
The ex-dividend date is the cutoff date established by a company to determine which shareholders are eligible for the next round of dividend payouts. Typically, on the ex-dividend date, a company’s stock price decreases roughly by the amount of the dividend to be paid out.
To illustrate this, let’s look at Procter & Gamble. When the company went ex-dividend in April 2022, its stock price decreased, reflecting the dividend payout’s value to be distributed among its shareholders.
Dividend Yield’s Role
The dividend yield, which is the annual dividend payout divided by the stock’s price, can also sway investor decisions. High dividend yields may indicate that the stock is undervalued, thereby attracting investors and pushing up the stock price.
The classic example here is AT&T. In late 2020, AT&T’s high dividend yield attracted a lot of income-focused investors, resulting in increased demand and a subsequent rise in its stock price.
Dividend Strategies for Investors
Now that we’ve covered dividends and the potential income they provide, let’s discuss a few popular dividend investment strategies.
1. Dividend Reinvestment
Dividend reinvestment is a strategy where the dividends you receive are not taken as cash but are instead used to buy more shares of the company. This is a powerful tool that can lead to exponential growth over time, thanks to the magic of compounding. By reinvesting your dividends, you increase your holdings of a company, which means you’ll receive even more dividends in the future.
Consider the case of an investor who bought shares of Coca-Cola in 1988. If they chose to reinvest their dividends, they would have significantly more shares and a much higher total return today than if they had taken their dividends as cash.
2. High Dividend Yield Investing
Another strategy is investing in companies with high dividend yields. The dividend yield is calculated by dividing the annual dividend by the current stock price. Companies with high dividend yields are often mature and financially stable, and can provide a consistent income stream. This strategy can be particularly appealing to investors looking for regular income, like retirees.
For example, utility companies like Duke Energy or real estate investment trusts (REITs) like Realty Income Corp are known for their high dividend yields and can be a good fit for this strategy.
3. Dividend Growth Investing
Dividend growth investing is a strategy that involves investing in companies that have a track record of consistently increasing their dividends year after year. The rationale behind this strategy is that a company that regularly increases its dividend is likely a financially healthy and growing business.
A shining example of this strategy would be investing in a company like McDonald’s, which has increased its dividend consistently for over 40 years. An investor who bought McDonald’s shares several decades ago would now be earning a high yield on the original cost of their investment.
4. Dividend Aristocrats and Dividend Kings
The Dividend Aristocrats are a group of companies in the S&P 500 that have increased their dividends for at least 25 consecutive years. Dividend Kings take it a step further, comprising companies that have raised their dividends for 50 years or more. Investing in these companies can provide stability and reliable income growth.
Prominent examples of Dividend Aristocrats and Kings include 3M Company, Johnson & Johnson, and Procter & Gamble.
Key Metrics for Dividends
These three key metrics – dividend yield, dividend payout ratio, and dividend growth rate – are indispensable tools for evaluating dividend-paying stocks. Let’s take a look at each and learn how they’re used.
Dividend Yield
Dividend yield is the annual dividend payment divided by the current market price of the stock. It is typically expressed as a percentage. This metric provides a snapshot of the income an investor can expect to earn from owning a stock, not accounting for any changes in the stock price.
Dividend Yield = Annual Dividends Per Share / Price Per Share
For example, if a company pays annual dividends of $2 per share and the current stock price is $40, the dividend yield is:
Dividend Yield = $2 / $40 = 0.05 or 5%
This means an investor receives 5% of their investment back as dividends each year.
Dividend Payout Ratio
The dividend payout ratio shows the percentage of a company’s earnings that is paid out to shareholders as dividends. This ratio can give investors an idea of how well a company’s earnings support the dividend payments.
Dividend Payout Ratio = Annual Dividends Per Share / Earnings Per Share
For example, if a company’s annual dividends per share are $2 and its earnings per share are $8, the dividend payout ratio is:
Dividend Payout Ratio = $2 / $8 = 0.25 or 25%
This means the company pays out 25% of its earnings as dividends, leaving a considerable proportion of earnings for reinvestment or to cushion future dividends.
Dividend Growth Rate
The dividend growth rate is the annualized percentage rate of growth of a company’s dividend achieved over a specified period. It indicates the pace at which the dividend amount is increasing.
For example, if a company’s dividend per share was $2 five years ago and is $3 now, the dividend growth rate is:
Dividend Growth Rate = ($3 / $2)(1/5) – 1 ≈ 0.084 or 8.4%
This means that the company’s dividend per share has grown at an average rate of 8.4% per year over the last five years.
The Dividend Discount Model
The Dividend Discount Model (DDM) is a method used to value a company’s stock by forecasting its future dividends. This model is based on the theory that a stock is worth the discounted sum of all its future dividend payments. In essence, the DDM allows investors to estimate the intrinsic value of a dividend-paying stock and compare it with the current market price to make informed investment decisions.
It’s typically applicable to firms that regularly distribute dividends, such as mature enterprises or companies in stable sectors like utilities or consumer staples. When used for companies with a consistent dividend track record, such as PepsiCo, it can yield accurate estimates of stock value.
However, the Dividend Discount Model comes with its limitations. Primarily, it is unsuitable for companies that do not distribute dividends. Many growth-focused firms, particularly in the tech industry, often channel their earnings back into the business instead of issuing dividends. In those cases, the DDM proves ineffective.
FAQs
When a company pays out dividends, its cash reserves decrease, impacting its total value. This adjustment is often reflected in a decrease in the stock’s price on the ex-dividend date.
The ex-dividend date is the date by which an investor needs to own a stock to be eligible to receive the declared dividend.
Dividends decrease a company’s retained earnings, a component of stockholder equity, as they are profits paid out to shareholders rather than reinvested in the company.
Some companies prefer to reinvest their profits into the business to fund growth and expansion rather than distribute them as dividends. This strategy is common among high-growth companies.
