I really do learn something new every day. It’s not too hard when it comes to stocks or investing since those subjects usually bore me, but I received a comment on an older post, Passive and Residual Income Defined, that got me interested, and JT from Money Mamba saved the day!
Adi: It’s true, passive income is the most rewarding by far. I earn only around $250 a month from passive income but I care about this so much more than what I earn from my other sources.
Question about the stocks: So far as I know, the dividend is subtracted from the share price every time it’s paid out. So, even though you get cash paid out, your total profit is zero. So how is it that you see dividends as a source of income?
Me: Adi, I have never heard about the dividends being taken out of the share price…where did you see that?
Adi: When I still had shares, it was normal (at least here in Europe). Every year when you got the dividend, your share price instantly dropped by that amount. They called this the ex-dividend price.
It makes sense in retrospect, because I should think market dynamics would ensure such a drop anyway. Or do you have a rule in the US that you only get a dividend if you hold the shares for a minimum time? But then that time threshold would be when the price drops.
So, I officially declare myself confused.
That’s when I called in the big guns, JT from Money Mamba. I knew he was way more into the investment arena than I am, so I asked for him to chime in to clear all of this up once and for all:
JT: The relationship between share prices and dividends isn’t 100% perfect. If you were to do a company valuation, then a company would technically be worth less after a dividend payout than before. If company X has a value of $100 before paying a $1 dividend, then it would be worth $99 after the dividend, as $1 is removed from the company’s cash on a per-share basis.
Whether or not this is reflected in the markets is case-by-case. In general, stocks that pay the highest dividends usually see the biggest drops after an ex-dividend date. If a company pays a $5 dividend on a $25 stock, then tons of investors are going to pile in before the dividend date and leave after. Thus, the buying and selling creates more volatility, and you’re more likely to see the dividend loss to cash priced in after.
In companies where the yield isn’t as high, the ups and downs with dividends are hardly noticed. Few people pile into a company to grab a .5% dividend payout, as the stock could easily move .5% between the purchase date and the dividend date.
The answer to the question can’t be a “yes” or “no” all the time. The price of stocks are based on supply and demand, and people who buy and sell them do them for different reasons. If a large part of the demand for stock is coming from people who want the one-time dividend, then you’re likely to see the price drop after the dividend comes. If, on the other hand, most of the demand for shares comes from long-term investors, the relationship is not at all 100% correlated.
In short, the big-time dividend stocks that everyone loves (Dividend Aristocrats) don’t see this kind of ex-divided pricing activity. However, the smaller companies that pay big dividend yields will, as will those which pay out HUGE one-time dividends.
Historically, dividend paying companies have been the best investments, and I can’t see that trend changing any time soon. The reality is that one dollar paid out in the form of dividends is $1 that can buy you a larger portion of the company. Meanwhile, $1 in cash on the books of your favorite company is just like having $1 in a savings account. Over the long-term, $1 in a company is going to provide much better returns than that $1 in a savings account.
That’s the short of it, but we can get way more finance-y if you’d like. I hope that makes sense.
Oh, and in the US, dividends are most often paid quarterly, so you would have to risk your money 4 times per year to get in and out for one year’s worth of ex-dividend dates.
In Europe, you need to risk it only once. I suppose this is why you see a lot more ex-dividend volatility in Europe than in the US.
So, yes, share prices do fluctuate based on dividend payouts, but it depends on the company on whether it’s noticeable or not. Good to know.
Am I the only one who didn’t know that dividends affected share prices?