Why Does the Value of a Share of Stock Depend on Dividends?
Dividend payments are the primary method companies share their profits with stockholders. Numerous investors rely on dividends for their living expenses and construct a stock portfolio primarily to maximize their dividend income. Dividend payments increase demand for a stock and consequently result in a higher stock price. Dividend payments also send a strong message to the investor community and boost the confidence of potential buyers.
A dividend paying stock produces a regular income stream for the investor, thereby reducing the impact of stock market fluctuations on a portfolio. Assume you have $200,000 to invest and must produce $10,000 from your stock investments every year to help cover your living expenses. If you can locate numerous stocks that pay an average of 5 percent dividend per year, your $200,000 investment will return $10,000 in dividend payments alone. This will eliminate the need to periodically sell stocks to raise enough cash. If, on the other hand, you invest in non-dividend paying stocks and must frequently liquidate part of your stocks to obtain cash, you may be forced to sell shares when the stock market is going through a rough patch. Therefore, investors often prefer dividend paying stocks, which boost demand and result in higher prices for such shares.
Even investors who do not need a regular stream of income prefer dividend-paying stocks, since regular dividends send a strong message about the financial viability of the corporation. Dividend payments are at the sole discretion of the board of directors. Shareholders cannot demand dividends if the board decides to suspend them. Unpaid creditors and suppliers, on the other hand, can sue the company and even force it into bankruptcy. If a firm is paying dividends, you can assume that it anticipates no difficulties honoring other payment obligations. As such, dividend payments improve investor confidence and increase the demand for the stock.
Dividend Record Date
In addition to the long-term increase in demand and the consequent rise in the stock price as a result of dividends, there is also a short-term fluctuation in the share price depending on the dividend cycle. Since shares of public corporations change hands very frequently, the issuing company only pays dividends to the investor who is holding the shares as of a certain date during the year. This is referred to as the dividend record date. The stock is said to go "ex-dividend" after this date, meaning the investor who purchases shares thereafter will not be entitled to receive that particular dividend. You will notice that the price of a stock declines on the ex-dividend date.
The increase in demand for dividend-paying stocks should not lead to the conclusion that receiving dividends is always better for the stockholder. Stockholders of companies with juicy growth prospects are sometimes better off not receiving dividends and have them instead reinvested into the business for maximum long-term growth. Shares of companies that pursue such a strategy are known as growth stocks. If most competitors are investing heavily to increase capacity or innovate cutting edge products, paying too much in dividends -- thereby not investing enough in the future -- can result in losing market share.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.