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It seems like stock prices rise when dividends increase unexpectedly [possible citation needed].

This doesn't seem intuitive to me, because if you think of stock as a claim of ownership on a company, announcing an increase in dividends doesn't necessarily make that company more valuable. Plus, even though you get some money back from the investment faster, it makes the company less able to grow in the future (because it will have less cash).

So, why would the stock price rise when this happens?

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A change in the dividend doesn't change a company's intrinsic value but it can affect investor valuation and investor sentiment which can then move share price.

If a company raises its dividend, it may be interpreted as a positive sign and lead to buying. Similarly, if it cuts the dividend, it may be interpreted as a sign of trouble and may result in a sell off.

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Stock prices don't always increase when dividends increase, and the variables are the things you mentioned.

You have to factor in that there are many people that are simply willing to accept a greater chance for more yield.

You have to also factor in the derivatives markets.

With a combination of options contracts and shares, you can reduce risk so much that you can borrow many multiples of your capital and passively collect dividends. So if the yield said 3% dividends, you can get your actual ROI up to 12% or maybe 20%. This is what many institutional investors are doing, and to create that position they need to buy the shares, before others do the same thing, hence the bidding war.

There are many circumstances that would result in there being less shares on the market, and people have to pay a premium if they want to own those shares themselves.

  • This doesn't explain why anyone expects the company's total return to be better just because the dividend increased. All else equal, the higher dividend would be be accompanied by stock price declines due to the payouts, and leveraging the dividend would be ineffective. That is the crux of the question. – nanoman Aug 21 '18 at 8:03
  • If you are hedging, options cost money and dividends are a a return of your own money from your brokerage account as share price is reduced on the ex-dividend date so how does your premise result in making a profit? Also, other than the occasional company buy back of shares, what are the circumstances that result in there being less shares on the market? – Bob Baerker Aug 21 '18 at 11:29
  • @BobBaerker The option strategy referred to is likely in-the-money covered calls being written (sold to open) against the stock position. Net option premiums would be additional income, not costs. The dividend yield on the net out of pocket cost of the combined position could be amplified, until the stock is later called away. But you lose out on potential gains in the stock price. – Chris W. Rea Aug 21 '18 at 12:18
  • @nanoman Some investors look for stable stocks which produce the best dividends. Look up dividend income investing, also look up dividend reinvestment plans (DRIP). These are similar investment strategies. The main idea is to build a portfolio which produces a passive income stream. – Xalorous Aug 21 '18 at 13:04
  • @Chris W. Rea - Share price is reduced by the amount of the dividend on the ex-dividend date so the presence of a dividend is meaningless. It's a covered call either way you execute it and its success is dependent on the stock rising. The dividend is Yield not Total Return. The amplification that you reference means just taking a larger position which means in terms of dollars, an equivalent bump up in risk and reward. – Bob Baerker Aug 21 '18 at 13:42
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A stock doesn't always go up when it announces a dividend increase, however when it does it can be good or bad depending on the situation.

When a company can increase its dividend regularly it is usually a good sign the company is profitable, and well managed. Yes you could say there is less money for the company to invest. A good company makes more money than it knows what to do with, and giving it out to shareholders is not the worst thing in the world.

A well manged company will typically try to keep its dividend to some percent of its profit, when your profits grow you can pay out more but relatively its not that different for the company. Lets put some numbers to this.

Assuming a company has $1.00 earnings per share in 2017, and pays out $0.20 per share as its dividend. The company is paying out 20% of its profits. It keeps 80% to reinvest. That is $0.80 per share. If they have a million shares outstanding that is $800,000 to work with.

Next year the company hits a home run and earns $2.00 per share. Now it can pay $0.40 per share. It is still only paying out 20% of earnings. so it still has 80% for research and development. But this time 80% is $1.60 per share, instead of $0.80 per share. Assuming they didn't buy back share, now they have $1.6 million to reinvest into the company.

If the company lacks any suitable reinvestment they may pay out more of the profits so the shareholders have a chance to invest that money on their own. Until the company finds more reasonable options to increase their profits.

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You are assuming that the company's future earnings are already known or at least that the dividend doesn't affect the market's estimate of those earnings. Indeed, under ideal conditions, the Modigliani-Miller theorem says that the company's value is independent of financial decisions such as dividends.

But an effect seems to exist as you say, perhaps because the market assumes the managers setting the dividend have special insight on the company's prospects, and it's customary to treat dividends as a "sticky signal" of sustainable earnings, with dividend cuts perceived as an embarrassing failure. So a company will raise its dividend only when it's reasonably confident of the future.

Related explanations are surveyed here.

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it makes the company less able to grow in the future (because it will have less cash)

Wrong assumption. Growing companies rarely give out dividends or give out big dividends, unless they are taken over or have a windfall gain somehow. Apple was an exception.

Mostly profitable, exceptions exist here also, mature companies give out big dividends e.g. energy distributions firms, energy majors etc. Mature companies have more than enough resources to fund expansions and giving out dividends isn't going to affect them much. They can finance their future projects quite cheaply from the markets by raising debt, so paying out dividends doesn't hamper them much. And rarely are major projects financed by only using one's own resources not using debt.

And secondly shareholders would ask a return from buying equity in a company whose share prices isn't going to skyrocket in prices in the near future else they would dump it and buy something else from where they will get a return. Most of the shareholders who expect a dividend are small investors, investment firms, pension funds etc.

This then comes to your question. A firm whose equity provides good returns is a magnet for people looking for good returns in the market. Everybody jumps in to buy and then demand supply takes effect on the price.

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A public company's job is to provide a return to the investors. If they do a good job, more people want to buy shares, and the share price increases. Consistently paying dividends, and meeting or exceeding dividend projections, is one way a company provides a return to investors. As long as the company continues to grow through innovation, expansion, acquisition, etc., paying dividends signals a healthy company.

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