What are Dividends and how do they affect stock prices?

Dividends are payments made by a company to its shareholders either from its earnings, profits or reserves. Distribution of dividends has to be decided by the company’s Board of Directors and must be approved by the shareholders by exercising their voting rights. Dividends are generally issued in the form of cash payments or equity.

Cash dividends- If a company has 10 million outstanding shares and issues a dividend of 10 cents, it means investors holding shares of the company will receive 10 cents for every share held. If an investor has 500 shares of the company, he/she will receive 500 * 0.10= $50 as dividends.

Stock dividends- These dividends on the other hand are issued in the form of additional shares rather than cash. For instance, if a company issues a 5 percent stock dividend, an investor who holds 100 shares of the company will receive 5 shares as dividends.

Impact on Stock Prices- Whenever a company declares dividends; irrespective of cash or equity, investors start buying into the company’s shares leading up to the ex-dividend date; the date before which you should own the company’s shares to be eligible for dividends, driving prices higher. All other factors remaining the same, the price increase will be as much as the dividend offered. However, on the ex-dividend date, investors could drive the stock prices lower by an amount equal to the dividend paid by the company, since new investors will not be eligible to receive dividends and therefore will stop paying a premium to buy the company’s shares.

Broadly, dividends can be a double edged sword. If the company offering dividends is performing extremely well and the future growth outlook is positive, then, irrespective of the dividend payout, the company’s shares will continue to rise even after the ex-dividend date. However, if the company is paying dividends only to keep its investor base happy, then the share prices will ease post the ex-dividend date.