Stock investing can be rewarding, but it is risky too. Predictions of future stock prices are notoriously hit and miss, no matter how much information is currently known about the stock. The best you can do as a stock buyer is study all the information at your disposal and make your best educated guess. Some events can occur that may change you appraisal of a stock, for better or for worse. A stock split is a neutral event, but it may become positive or negative if it is accompanied by a change to dividends.
As a stockholder, you are a partial owner of the corporation and have the right to benefit from company earnings. One direct benefit of owning shares is collecting a dividend, which puts cash directly into your pocket. A second benefit is a rising stock price. Should you decide to sell your shares, you will experience a capital gain, which also puts money in your pocket. Stock prices rise for a number of reasons, including good corporate earnings, improved economic conditions, takeover offers from other firms and a favorable disposition of a lawsuit.
The board of directors may welcome higher stock prices, but they may perceive a problem if the prices go too high. A common sentiment on Wall Street is that high stock prices scare away the “small investor." In response, the board can declare a stock split, which increases the number of shares outstanding while cutting the price of each share. For example, if XYZ Corporation stock rises to $150 a share, the board might declare a three-for-one stock split. If you owned 100 shares before the split, you now own 300 shares, each priced at $50.
Dividends paid per share can be a powerful motivator for income-oriented stock investors. Dividend yield is the dividend per share divided by the price per share. When a stock price rises, the dividend yield declines unless the board decides to raise the dividend amount. Boards can pursue a policy of dividend growth, which increases the dividends per share each year. But some boards adopt a more aggressive strategy of dividend yield growth, in which the annual dividend grows enough to provide higher dividend yields every year. During years when the stock price rises, the board may have to approve large dividend increases to maintain their policy of growing dividend yields.
Stock Spits and Dividends
A stock split has no intrinsic effect on dividend growth rate. When a corporation announces a split without a change to dividend yield, the dividends per share are cut in the inverse ratio to the split. For example, if XYZ was paying a $3/share annual dividend before the three-for-one split, the after-split dividend per share is $1 and the dividend yield remains unchanged at 2 percent, which is the $1 dividend divided by the $50 stock price. However, a confident board will often increase dividends after a stock split. For example, in January 2011, a Wisconsin utility declared a two-for-one stock split and a 30 percent increase in dividends. Over the next two years, the stock price appreciated by 33 percent, indicating the board’s confidence was well-placed.
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