Dividends can affect the price of the underlying stock in a variety of ways. While the dividend history of a given stock plays a general role in its popularity, the declaration and payment of dividends also has a specific and predictable effect on market prices.

It stands to reason that the possibility of creating recurring investment income encourages investors to purchase and retain shares of stock. While this motivation may seem to be purely economical, the underlying beliefs about the company's profitability are what impact stock prices the most. To understand how dividends positively affect investor thinking, it helps to first understand the mechanics of the stock market and the basic of how dividends work.

Market Psychology

The stock market is the collective result of the decisions of millions of investors. Though stock prices are based on the value of the issuing company, fluctuations in the stock market are largely dictated by human psychology. If an investor thinks the future is bright for a given company, she wants to invest as soon as possible to reap the maximum profit. If enough investors feel the same way, the increase in investment drives the stock price up, thereby fulfilling the investor's prediction. Conversely, shareholders who think a stock is about to take a dive sell quickly to avoid losses.

If enough shareholders buy or sell around the same time, other investors begin to think that they've missed out on some crucial piece of information. Especially among individual retail investors, the baseline assumption is generally that others know more than you do, so it behooves you to follow the herd. This mentality often results in previously neutral investors suddenly entering the fray to avoid missing out on profits or incurring losses, further exacerbating the effect.

Essentially, when the collective opinion of investors is positive, stock prices go up. When the general consensus is less than optimistic, prices drop. Despite the seemingly complex nature of the market, most activity truly boils down to the cumulative effect of investors trying to predict what their peers are thinking. Basically, it's all one big guessing game with financial consequences that are anything but trivial.

How Dividends Work

For investors, dividends serve as a popular source of investment income. For the issuing company, they are a way to redistribute profits to shareholders as a way to thank them for their support and to encourage additional investment. Dividends also serve as an announcement of the company's success. Because dividends are issued from a company's retained earnings, only companies that are substantially profitable issue dividends with any consistency. Though some companies may issue dividends to create the illusion of profitability, this is the exception rather than the rule.

Dividends are often paid in cash, but they can also be issued in the form of additional shares of stock. In either case, the amount each investor receives is dependent on their current ownership stakes.

If a company has 1 million shares outstanding and declares a 50-cent dividend, then an investor with 100 shares receives $50 and the company pays out a total of $500,000. If it instead issues a 10% stock dividend, the same investor receives 10 additional shares, and the company doles out 100,000 new shares in total.

When a dividend is paid, the total value is deducted from a company's retained earnings. "Retained earnings" refers to the total amount of profit a company has accumulated over time that has not been put to other uses. Essentially, it is the amount of money a business has on account that it can use to pay dividends or fund growth projects.

The Effect of Dividend Psychology

Stocks that pay consistent dividends are popular among investors. Though dividends are not guaranteed on common stock, many companies pride themselves on generously rewarding shareholders with consistent – and sometimes increasing – dividends each year. Companies that do this are perceived as financially stable, and financially stable companies make for good investments – especially among buy-and-hold investors who are most likely to benefit from dividend payments.

When companies display consistent dividend histories, they become more attractive to investors. As more investors buy in to take advantage of this benefit of stock ownership, the stock price naturally increases, thereby reinforcing the belief that the stock is strong. If a company announces a higher-than-normal dividend, public sentiment tends to soar.

Conversely, when a company that traditionally pays dividends issues a lower-than-normal dividend, or no dividend at all, it may be interpreted as a sign that the company has fallen on hard times. The truth could be that the company's profits are being used for other purposes – such as funding expansion – but the market's perception of the situation is always more powerful than the truth. Many companies work hard to pay consistent dividends to avoid spooking investors, who may see a skipped dividend as darkly foreboding.

The Effect of Dividend Declaration and Distribution

Before a dividend is distributed, the issuing company must first declare the dividend amount and the date when it will be paid. It also announces the last date when shares can be purchased to receive the dividend, called the ex-dividend date. This date is generally two business days prior to the date of record, which is the date when the company reviews its list of shareholders.

The declaration of a dividend naturally encourages investors to purchase stock. Because investors know that they will receive a dividend if they purchase the stock before the ex-dividend date, they are willing to pay a premium. This causes the price of stock to increase in the days leading up to the ex-dividend date. In general, the increase is about equal to the amount of the dividend, but the actual price change is based on market activity and not determined by any governing entity.

On the ex-dividend date, the exchange reduces the stock price by the amount of the dividend to account for the fact that new investors are not eligible to receive dividends and are therefore unwilling to pay a premium. However, if the market is particularly optimistic about the stock leading up to the ex-dividend date, the price increase this creates may be larger than the actual dividend amount, resulting in a net increase despite the automatic reduction. If the dividend is small, the reduction may even go unnoticed due to the back and forth of normal trading.

Many people invest in certain stocks at certain times solely for the purpose of collecting dividend payments. Some investors purchase shares just before the ex-dividend date and then sell them again right after the date of record – a tactic that can result in a tidy profit if it is done correctly.

A Note About Stock Dividends

Though stock dividends do not result in any actual increase in value for investors at the time of issuance, they have an effect on stock price similar to that of cash dividends. After declaration of a stock dividend, the stock's price often increases. However, because a stock dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.

As with cash dividends, smaller stock dividends can easily go unnoticed. A 2% stock dividend paid on shares trading at $200 only drops the price to $196, a reduction that could easily be the result of normal trading. However, a 35% stock dividend drops the price down to $140 per share, which is pretty hard to miss.

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