Investors make money from stocks they own in two ways: selling the stocks when the price goes up and receiving dividends from the shares they own. However, buying right before a dividend and selling right after isn't usually a way to make money because the market responds to dividend payments by adjusting the stock price for the value of the payment.
When a company declares a dividend, it's promising to pay investors from its own cash pool based on the number of shares that each person owns. For example, if a company declares a $1 million dividend, that company has to come up with $1 million in cash to make the payments. When the company announces a dividend, it also sets a record date, which is the date you need to be recorded as a shareholder to receive the dividend. Whoever owns the stock on that date gets the dividend payments.
Effects on Stock Price
Because paying a dividend lowers the amount of money a company is worth, the stock market responds by lowering the price of the company's shares. For example, say a company is worth $50 million and has 2.5 million shares outstanding. Based on that valuation, an investor would be willing to pay $20 per share. If the company pays a $1 million dividend, or 40 cents per share, the company would still have 2.5 million shares outstanding, but only be worth $49 million. So, after the dividend the market would only value the stock at $19.60 per share.
No Loss for Current Shareholders
Even though the price of the stock goes down after a dividend, current shareholders don't lose out. Instead, their wealth just takes a slightly different form -- it's split between the reduced share value and the dividend payment. For example, say you owned shares worth $20 each before a 40-cent per share dividend. After the dividend, your stock is only worth $19.60. However, you now have 40 cents in your pocket from the dividend payment. Adding that 40 cent dividend to your share value of $19.60 puts your total worth at $20 -- right where you were before the dividend.
Another disadvantage to buying and selling shares in a short period of time is higher tax rates on any profits you might make. Any time you earn a profit from selling stock you've owned for a year or less, those profits are taxed at your ordinary income tax rates, rather than the lower long-term capital gains rates. In addition, if you don't own the stock for more than 60 days during the 60 days before and 60 days after the stock's ex-dividend date, your dividends can't be qualified dividends, which means the payment is also taxed at your higher ordinary tax rates.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."