Please explain the relationship between dividend amount, stock price, and option value?

Question

I consider myself a reasonably knowledgeable investor, but today was blown away by the fact that I didn't know that a stock's price is decreased by the amount of its dividend. To use a concrete example (these numbers are roughly correct but not exact to the penny):

Nokia (NOK) closed at 9.31 yesterday, and paid a 5% dividend. So its open price was 8.86 today, and it seems to be trading normally, as if its price was "normally" 8.86.

So a few questions:

1. What's the point of paying a dividend if the stock price automatically decreases? Don't the shareholders just break even?

2. I assume the price of the stock "naturally" increases over the year to reflect the amount of the dividend payment. This is kind of a vague question but then doesn't it make it difficult to evaluate the fluctuations in stock price (in the way that you would a company that doesn't pay a dividend)?

3. With respect to options, I assume nothing special happens? So say I bought $9 call options yesterday that were in the money, all of a sudden they're just not? Is this typically priced into the option price? Is there anything else I need to know about buying options in companies that pay dividends? What if I had an in-the-money option, and all of a sudden out of nowhere a company decides to pay a dividend for the first time. Am I just screwed?

4. Finally, do all companies reduce their stock price when they pay a dividend? Are they required to? I'm just shocked I've never heard of this before.

Sorry that's a lot of questions - just looking for some general information here since this is all new to me.

Answer 1

There are a few reason why the stock price decreases after a dividend is paid:

• The stock price automatically decreases by the dividend amount to reduce "dividend capture", which is a form of arbitrage when traders try to buy a stock days before an expected divident and try to sell it a bit later, capturing the dividend as pure profit.
• Stocks that pay dividends are making the choice to reward the stockholder with cash instead of reinvesting profits into the company to grow its business. When a pile of money gets paid to stockholders, that's a signal that the long term growth potential is decreased (compared to if it had reinvested the money), at least a little bit. A dividend payment is an outflow of cash, so the company is worth less, and so its stock should probably be priced less as well.

What's the point of paying a dividend if the stock price automatically decreases? Don't the shareholders just break even?

Companies have to do something with their profits. They beholden to their shareholders to make them money either by increasing the share value or paying dividends. So they have the choice between reinvesting their profits into the company to grow the business or just handing the profits directly to the owners of the business (the shareholders). Some companies are as big as they want to be and investing their profits into more capital offers them diminishing returns. These companies are more likely to pay dividends to their shareholders.

I assume the price of the stock "naturally" increases over the year to reflect the amount of the dividend payment. This is kind of a vague question but then doesn't it make it difficult to evaluate the fluctuations in stock price (in the way that you would a company that doesn't pay a dividend)?

It depends on the company. The price may recover the dividend drop... could take a few days to a week. And that dependings on the company's performance and the overall market performance.

With respect to options, I assume nothing special happens? So say I bought $9 call options yesterday that were in the money, all of a sudden they're just not? Is this typically priced into the option price? Is there anything else I need to know about buying options in companies that pay dividends? What if I had an in-the-money option, and all of a sudden out of nowhere a company decides to pay a dividend for the first time. Am I just screwed?

One key is that dividends are announced in advance (typically at least, if not always; not sure if it's required by law but I wouldn't be surprised). This is one reason people will sometimes exercise a call option early, because they want to get the actual stock in order to earn the dividend.

For "out of the ordinary" large cash dividends (over 10% is the guideline), stock splits, or other situations an option can be adjusted: http://www.888options.com/help/faq/splits.jsp#3 If you have an options account, they probably sent you a "Characteristics and Risks of Standardized Options" booklet. It has a section discussing this topic and the details of what kinds of situations trigger an adjustment. A regular pre-announced <10% dividend does not, while a special large dividend would, is what I roughly get from it.

That "Characteristics and Risks of Standardized Options" is worth reading by the way; it's long and complicated, but well, options are complicated.

Finally, do all companies reduce their stock price when they pay a dividend? Are they required to? I'm just shocked I've never heard of this before.

The company doesn't directly control the stock price, but I do believe this is automatic. I think the market does this automatically because if they didn't, there would be enough people trying to do dividend capture arbitrage that it would ultimately drive down the price.

Answer 2

4) Finally, do all companies reduce their stock price when they pay a dividend? Are they required to?

There seems to be confusion behind this question. A company does not set the price for their stock, so they can't "reduce" it either. In fact, nobody sets "the price" for a stock. The price you see reported is simply the last price that the stock was traded at. That trade was just one particular trade in a whole sequence of trades. The price used for the trade is simply the price which the particular buyer and particular seller agreed to for that particular trade. (No agreement, well then, no trade.) There's no authority for the price other than the collection of all buyers and sellers.

So what happens when Nokia declares a 55 cent dividend? When they declare there is to be a dividend, they state the record date, which is the date which determines who will get the dividend: the owners of the shares on that date are the people who get the dividend payment. The stock exchanges need to account for the payment so that investors know who gets it and who doesn't, so they set the ex dividend date, which is the date on which trades of the stock will first trade without the right to receive the dividend payment. (Ex-dividend is usually about 2 days before record date.) These dates are established well before they occur so all market participants can know exactly when this change in value will occur.

When trading on ex dividend day begins, there is no authority to set a "different" price than the previous day's closing price. What happens is that all (knowledgeable) market participants know that today Nokia is trading without the payment 55 cents that buyers the previous day get. So what do they do? They take that into consideration when they make an offer to buy stock, and probably end up offering a price that is about 55 cents less than they would have otherwise. Similarly, sellers know they will be getting that 55 cents, so when they choose a price to offer their stock at, it will likely be about that much less than they would have asked for otherwise.

Answer 3

The exchanges artificially push the price of the stock down on the ex-div date. Often the impact of paying the dividend is absorbed by the ebb and flow of trading in the stock later in the day by the market. I think this was noticable with Nokia because the company is in poor shape and the stock has plunged recently.

Dividends are a great way for companies to return value to shareholders. The trend for many companies, particularly growth stocks is to reinvest profits to grow the company. Former growth stocks like Microsoft like to just sit on billions of dollars and do nothing with it.

Answer 4

Regarding:

1) What's the point of paying a dividend if the stock price automatically decreases? Don't the shareholders just break even?

As dividends distribution dates and amounts are announced in advance, probably the stock price will rise of the same amount of the divident before the day of distribution. If I know that stock share A's value is y and the dividend announced is x, I would be willing to buy shares of A for anything > y and < than x+y before the distribution.So, arbitrageurs probably would take the price to x+y before the dividend distribution, and then after the dividend distribution the price will fall back to y.

Answer 5

1) What's the point of paying a dividend if the stock price automatically decreases? Don't the shareholders just break even?

When the company earns cash beyond what is needed for expenses, the value of the firm increases. As a shareholder, you own a piece of that increased value as soon as the company earns it.

When the dividend is paid, the value of the firm decreases, but you break even on the dividend transaction.

The benefit to you in holding the company's shares is the continually increasing value, whether paid out to you, or retained.

Be careful not to confuse the value of the firm with the stock price. The stock price is ever-changing, in the short-term driven mostly by investor emotion. Over the long term, by far the largest effect on stock price is earnings.

Take an extreme, and simplistic example. The company never grows or shrinks, earnings are always the same, there is no inflation :) , and they pay everything out in dividends. By the reasoning above, the firm value never changes, so over the long-term the stock price will never change, but you still get your quarterly dividends.

Answer 6

To show the link between stock price dividend amount and option value, I'm going to show three option pricing tables. But before we look at that, I'll start with the original questions observation about the adjustment in stock price on ex-dividend date. They posit this seems to be a zero-sum game.

On Ex-date, the stock price is lower by the value of the dividend because the company has a lower value having paid out the dividend. But only for that moment in time. The future growth and prospect of the firm should rally the stock by more than the dividend amount. It just won't happen on the morning of the ex-dividend. There's a sound logic of how dividends are handled on ex-dividend date - but you need to take a longer-term view of the company's value.

OK, onto the options. I was going to post tables, but - I have no stinkin' badge..lol.

So instead of showing the change in the combo, etc. I'll explain the relationship like this:

View the ex-dividend adjustment of the stock as separate from the adjustment to the option prices.

The day before xd, the combo has the dividend priced into the options. on xd, the STOCK price is lowered by the value of the option. and here's the piece most people miss... The options no longer include that dividend. So the options prices are adjusted twice, in a sense. For the XD: calls lower, puts higher (due to lower stock price which is div) For the Div leaving option value: calls higher, puts lower (due to one dividend falling out of our BSM calc).

Separating out the effect of each event will make the relationship clearer.

Enjoy your evening!