15

My limited understanding is that a stock's share price typically goes down on its ex-dividend date by the amount of the dividend. If that's true, why are dividend equities generally considered good investments? It sounds like investors would just break even each time a dividend is issued because the value of their equity typically goes down by the same amount as the dividend.

In other words, if an investor does not need an income stream from dividends, do dividend stocks have advantages over non-dividend stocks?

10
  • 3
    imagine a stock that goes from 100 to 110, issues a $5 dividend, then goes down to 105. It is still up 5% on its original price, in addition to the dividend the owner received. Going down after the dividend doesn't mean going down to what was paid for it. – Kate Gregory Feb 16 at 18:48
  • 5
    @Kate Gregory - The dividend and price share reduction is irrelevant. Before the dividend, you're up 10% in capital gain. After the dividend you're up 5% in capital gain and 5% in dividend. Ignoring taxation differences, 10% is the same as 10%. And that leads to another point. If the dividend is received in a non sheltered account, you're going to pay taxes on the dividend for the privilege of receiving your own money back on the dividend's Pay Date. – Bob Baerker Feb 16 at 20:00
  • 5
    I know. That was my point – Kate Gregory Feb 16 at 20:01
  • 5
    If you were intending to buy more shares and the stock has a dividend reinvestment plan, you can do slightly better than break even because you'll save brokerage costs and sometimes receive a small discount on the price. I don't know if that's a significant enough advantage over fundamentals though. – LoztInSpace Feb 16 at 22:42
  • 1
    @RockPaperLz-MaskitorCasket Sometimes the issuer will decide to discount on DRP to encourage cash retention and shareholder loyalty (or whatever other reasons - I don't decide :) ). It's typically only a percent here or there if indeed there is anything (it's not that common). A recent example is ASX:SCP last dividend gave a 1% discount on the 10 day VWAP for DRP shares. The $0 brokerage advantage also brings down the price but not in the form of a discount as such. – LoztInSpace Feb 17 at 10:47
21

There is not a direct advantage (meaning that do not produce actual wealth as you mention), but it can be an indication that the company is a good stable investment. If a company pays dividends, then typically that means that the company is healthy enough (has enough excess cash flow) that it can redistribute it to shareholders rather than investing it back in the company.

In academic theory, the premise is that a dividend means that shareholders can invest the cash better than the company can, which is an indication that the company is mature enough to be able to pay dividends and may be limited in ways to invest it internally.

Certainly there can be exceptions, and some companies can pay dividends even if they can't afford to, but it is one way to look at dividends in general.

13
  • 1
    In other words the company is done growing and is now making a profit "for real" instead of just on paper? – user253751 Feb 17 at 10:52
  • 1
    @StianYttervik The owners of a company (=the shareholders) expect to earn money for their investment. This is the same, no matter whether you have a 3 people car repair shop or a multi billion mega corporation. After all, dividends are the only way to get money out of your portfolio without selling your shares. Admittedly, some companies lean more on the reinvest-and-grow side, e.g. Amazon. But for most mature companies, investors expect to get a dividend payed out – Manziel Feb 17 at 13:27
  • 1
    @StianYttervik It's not that they don't know what to do with it, but that their options have lower return or higher risk. Again, that's one academic theory of dividends; in practice it's not always that scientific. Sometime the board just wants to get cash onto the owners' hands even if they could put it to better use internally. – D Stanley Feb 17 at 13:59
  • 2
    In (rough) academic theory, the fundamental value of a stock is based on its dividends. I'm not aware of any generally-accepted economic theory that explains how a investment that never generates income can have value. In academic terms, such investments are called 'bubbles'. – JimmyJames Feb 17 at 19:36
  • 2
    @DStanley Valuation methods are practical, not academic. If you can show me a reference to a theory of non-income generating investments, I'd love to read about it. Your point about 'hopefully will eventually get realized through dividends' is right on target with my point, though. It's not the current or past dividends, it's the NPV of the future income streams (cash flows) which forms the basic theory of valuing investments. – JimmyJames Feb 17 at 20:08
7

It avoids building castles in the air

Extremely simplified: there are two factors contributing to a stock price. The first part is a fundamental value, based on the company's earnings, its dividend, the expected future growth. Analysts make this look like an exact science by computing two digits behind the comma but it is not. Predictions about the future are inherently difficult and uncertain. The price reduction on the ex-dividend date is coming from a fundamental change: the company has just distributed a lot of money to its shareholders.

The other major factor contributing to a stock price is the expectation of being able to sell this at a higher price at some point. GME was a prime example of this. Everybody knew that the fundamentals hardly justified even $40 but the expectation that you might be able to sell your shares to a hedge fund at $300, $400 or $1000 made many people jump on board. The same principle applies to many of the currently hyped stocks. Hydrogen may be a part of the future but does this really justify to value some of the companies at 100 times their revenue? Probably not. And most of those companies to not even make any earnings to pay dividends. This practice is based on the assumption that you will find some greater fool to buy it for even more money. But over the long run these castles in the air have mostly been corrected a stock going down rather than the company growing into their valuation.

One advantage of high dividend stocks is that their valuation tends to be more based on fundamentals. That does not necessarily make them a good investment in any case, even if we assumed there is no fraud going on. Your profitable airline could be hit by a pandemic, an oil company could become obsolete by bans on combustion cars, etc. But a company paying a reasonable dividend has a good chance to be a fundamentally good investment.

1
  • As the other example shows, Enron proved that you could build castles in the air and still pay dividends. I believe the issue at hand is more fundamental than you describe: a dividend is usually paid from free cash flow. Having a high free cash flow gives a company flexibility to adapt. – MSalters Feb 18 at 13:52
5

Just for clarification, a stock's share price drops by the exact amount of the dividend on its ex-dividend date. When trading begins anew that morning, the stock may go up, down or be unchanged.

You are correct. Investors just break even each time a dividend is issued because the value of their equity goes down by the same amount as the dividend. A dividend does not provide total return.

Here's an extreme comparison of two stocks:

If my recollection is correct, in its heyday, Enron paid about a 3% dividend. Some might think that for what was believed to be a quality stock at the time that 3% was decent. We all know what happened to Enron. Kaput!

And then there's GameStop. Anyone who bought it in the high teens and lucky enough to get out in the high $400 area made a bundle.

The point of this absurd comparison? You should be investing in high quality companies that are leaders in their sector with strong (and growing) free cash flow, low debt, and good management. If they pay a dividend, fine. If not, no big deal.

PS GameStop and Enron are/were not high quality.

3
  • This answer would be stronger if it would use more representative examples. Enron didn't fail because it gave out dividends. Gamestop didn't go up because it didn't. Both were the results of black swan events. A better comparision could be to pick some popular stocks from the same industry with some giving out dividends and others which do not and comparing their long-term performance. – Philipp Feb 18 at 10:37
  • 1
    Anyone can find a pair of popular stocks from the same industry with some giving out dividends and others which do not and comparing their long-term performance. Selecting other stocks doesn't improve the conclusion. – Bob Baerker Feb 18 at 16:53
  • I do not understand what these examples are supposed to show. – Relaxed Feb 19 at 11:36
2

What you are missing is that the price of the stock tends to rise the amount of the dividend between the announcement and the ex-dividend date as explained in this article the section titled The Effect of Dividend Declaration on Stock Price. This has been shown to be empirically true in many academic studies. In addition, this increase is 'real' i.e. it's based on actual trades and not on regulatory rules. The 'price drop' you are referring to is required by all exchanges in the US to prevent unsuspecting or inattentive investors from buying stocks at the inflated pre-dividend price when they will not receive it. If this rule was not in place, it would be easy to buy stocks right before the ex-dividend date and then sell them to suckers at that price after taking the dividend. Claims that this price drop is related to the book value of the company or whatnot are confused. The price increase and subsequent decrease around dividend issuance are transactional and not related to the 'real' value of the stock.

Really the real question here is whether the company can make better returns on the cash that would be required to pay the dividend. Hypothetically, assume we have a company that can afford to issue a dividend. It has plenty of cash flow and it has no good opportunities to expand in it's current operations. The management has a few options. They could enter a new type of business. They could give themselves bonuses. They could upgrade the corporate jet or build/buy a fancy new building. They could do a share buyback. Or they could issue a dividend. Should they enter a new type of business? This happens a lot and often fails miserably. You might prefer to get the cash and invest it in another company that is known to be successful in that area. New corporate jet or facilities etc.? Maybe that improves morale or attracts talent and is therefore worthwhile but is probably dubious in lot of cases. Share buybacks can help increase the value of a stock but it's not guaranteed.

Dividends come with some downsides with regard to taxes (especially for the very wealthy) and they do remove resources for the company. I'm not saying they are always a good thing. But this idea that you always break-even or worse on dividends is just plain bunk. Companies are not bank accounts. The value of a stock is based primarily on it's cash flows, not the amount of cash it holds at any one moment.

The most fundamental relationship between dividend-paying stocks and their share price is that the stock price of dividend-paying company with solid fundamentals is not going to drop below a certain price (based on a number of factors.) When the price goes down, the yield goes up. If the yield goes up enough, the stock will be purchased due to arbitrage, if nothing else.

7
  • 1
    There are some misunderstandings in this answer. In particular, the price rise referred to on your link after dividend declaration is not 'immediate', it is incremental over time, mostly in the final days prior to the ex-dividend date. "This causes the price of a stock to increase in the days leading up to the ex-dividend date." Also, the exchange does not 'require' the price to drop after the ex-dividend date, it is indeed the natural mechanism of a company with, say $10M less in cash being valued in total $10M less than it did the day before. – Grade 'Eh' Bacon Feb 17 at 20:29
  • 1
    @Grade'Eh'Bacon Where did I suggest this rise was 'immediate'? That word doesn't appear in my answer anywhere. – JimmyJames Feb 17 at 20:31
  • @Grade'Eh'Bacon Sorry, that was the wrong link:finra.org/rules-guidance/rulebooks/finra-rules/5330: "A member holding an open order from a customer or another broker-dealer shall, prior to executing or permitting the order to be executed, reduce, increase, or adjust the price and/or number of shares of such order by an amount equal to the dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest, except where a cash dividend or distribution is less than one cent ($0.01), as follows ..." – JimmyJames Feb 17 at 20:35
  • The way I read your answer, it implies that the price drop itself is mandated by the exchange [which has no ability to dictate share price], rather than the fact that the announcement of dividend dates must be made. As to the price rise being immediate, I seem to have read to deeply into the implications of what you were saying, and I retract that comment. As a side note, consider that there is a difference between expected and unexpected dividends; if a dividend is unexpected, it is potentially a reflection of profits being higher than previously known , which increases apparent value. – Grade 'Eh' Bacon Feb 17 at 20:35
  • Adjusting order books for orders made before dividends is not the same as saying the price it is traded at is changed. If a company had no orders already on the order books, there would still, barring illiquidity or an ignorant trader, be a price drop for that security after the ex dividend date. – Grade 'Eh' Bacon Feb 17 at 20:37
2

"a stock's share price typically goes down on its ex-dividend date by the amount of the dividend"

yes, and theoretically it would stay there for a longer sustained period of time.

but the market is irrational and moves commensurate to collective human emotion. so in practice, after the market price per share drops at 9:30 AM on the ex-dividend date, investors often "fill the gap" by market close or by EOW (the end of the week). there's no one and nothing stopping investors or traders from trading shares at the reduced price or bidding the price back up to the levels it was at before the stock went ex-dividend.

"do dividend stocks have advantages over non-dividend stocks"

this is hotly debated. I'd say dividend stocks are more established in the sense that they are profitable and have been for some time. they can be perfect for conservative investors because they provide consistent quarterly cash flow. I'm not a fan, because I prefer more aggressive trading strategies: growth stocks and complex tech goods and services that can offer larger appreciation opportunities. it depends on your risk tolerance.

0

My laymans understanding is that a dividend is money now, whereas share price growth is (hopefully) money in the future. Money now is usually more useful than the hope of some in the future.

The answer to your question is "it depends". Lets say you invested in two companies. One pays a dividend, the other doesn't. They both have a 5% year-on-year share price increase - clearly the divdend payer is the better investment because you're getting "bonus" payments each year (which you can invest in the same or different companies). However, if the non-dividend payer has 6% year-on-year share price increases, then it may be the better choice. If you can use your dividend payments to make more money than that share price improvement difference, then the dividend payer is still the better choice.

To boil it down a bit further (past performance is no guide to the future):

Non-dividend payers

Look at share price increases over time. This is the return you might expect in the future.

Dividend payers

Look at the share price increases over time. Call this "X". Look at how much money you would have been paid in dividends (and when). Figure out who you would have invested that money into, and look at the share price increases there - call this "Y". Look at any dividends paid by the additional company and repeat the process. Call this Z. Your return from this investment is X + Y + Z.

Bear in mind that dividends get paid on different schedules. Thus you'll end up with quite a complex calculation of what returns you're getting because of different lengths of investment in different shares, and compound growth etc.

1
  • 1
    For simplicity, instead of 'figuring out who you would reinvest the dividends into', simply presume that you would reinvest in the same company that paid the dividend. This is the simpler way to show that the dividend payment is not 'gaining' you anything, all-else being equal. – Grade 'Eh' Bacon Feb 17 at 20:22
0

In other words, if an investor does not need an income stream from dividends, do dividend stocks have advantages over non-dividend stocks?

With the premise that you are not trying to setup an income stream from the dividend, then there is no advantage that comes from getting a dividend from a stock.

If the stock is in a taxable account then you get to pay taxes on the dividends.

While there is a big debate about the movement of the price around the time of the dividend, there is zero relationship between the overall direction of the stock price and the presence of the dividend.

Companies generally don't set the dividend for this quarter based on the quarterly profits, they are hesitant to drop the dividend amount because a drop in dividend is considered bad news. Some will continue to be stubborn as they bleed cash but still pay the same dividend. Others will raise the dividend slowly because being able to raise it every year is a good sign.

On the other hand the lack of a dividend doesn't mean you can't make money from the time you own the stock.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.