What is the point of a stock's dividend?
There has been a lot of discussion on the purpose of dividends in what we like to call “dividend stocks”.
When shareholders are paid a dividend, the stock price will drop by the dividend amount. Then, the company seems to be worth less by the dividend amount.
If all this is true, what is the point of a dividend? Does the decrease in stock price nullify the dividend?
Why dividends appear to be useless
Let me present you with a scenario.
Suppose we own company stock,
$10 per share, that has nothing affecting the value of the stock except for the dividend. The ex-dividend date is announced and expected to be
$1 per share.
After the dividend is paid out, this stock is valued at less by an amount equal to the dividend after the stock has gone ex-dividend.
So, in the short term, this stock loses value after paying the dividend.
Why dividends are not useless
The price of the stock decreases because it had gone up in anticipation of the dividend prior to the ex-dividend date. After this date, it is now returning to its “normal” level.
So, in our ideal scenario above, the stock price would rise to
$11 up until the ex-dividend date, and then it would return to
$10 after the dividend is paid out.
Those that buy the stock just before the dividend get the stock plus the dividend, while those that buy after the dividend only get the stock. In this ideal market we’re working with, this price pattern is expected.
Without the dividend, a stock price would never have gone up in the first place.
Of course, daily trading patterns and price movement will affect the stock price as well, so this pattern is not guaranteed in real, live markets, but it is still accounted for in the stock price.
What value of a stock means
All that said, we can’t look at a stock ex-dividend price and say that we lost value as a shareholder.
The value of a stock is not simply equal to the value of company assets minus liabilities, divided by the total number of shares, which is what is shown on a company’s balance sheet. Rather, it is a complex composition of total assets, liabilities, and anticipated future earnings, which is almost impossible to predict but reflected in the price movement.
The reality is that it doesn’t matter if the stock price decreases after the dividend because the price movement from trading will alter the price based on the company’s anticipated future earnings… as it does every day.
It can drop by less than the dividend amount. It can drop by more than that amount. It can even go up by more than that amount, increasing the shareholder’s value.
We never assume that share price will stay the same over the course of a few days.
Why should we invest in dividend stocks?
Dividends have plenty of benefits.
- Dividends lower our cost basis and, if reinvested, can provide additional shares that can compound if share price appreciates
- Dividends can produce a consistent stream of income and can supplement the income of those still working
- Stocks with higher dividends tend to attract investors, potentially adding to the increase of the stock price over time