Dividends can affect the price of their 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 one 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, investors may drive down 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.

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.

Dividend Yield/Payout Ratio

The dividend yield and dividend payout ratio are two valuation ratios investors and analysts use to evaluate companies as investments for dividend income. The dividend yield shows the annual return per share owned that an investor realizes from cash dividend payments, or the dividend investment return per dollar invested. It is expressed as a percentage and calculated as:

Dividend yield = annual dividends per share ÷ price per share

The dividend yield provides a good basic measure for an investor to use in comparing the dividend income from his or her current holdings to potential dividend income available through investing in other equities or mutual funds. In regard to overall investment returns, it is important to note that increases in share price reduce the dividend yield ratio even though the overall investment return from owning the stock may have improved substantially. Conversely, a drop in share price shows a higher dividend yield but may indicate the company is experiencing problems and lead to a lower total investment return.

The dividend payout ratio is considered more useful for evaluating a company's financial condition and the prospects for maintaining or improving its dividend payouts in the future. The dividend payout ratio reveals the percentage of net income a company is paying out in the form of dividends. It is calculated using the following equation:

Dividend payout ratio = annual dividends per share ÷ earnings per share

If the dividend payout ratio is excessively high, it may indicate less likelihood a company will be able to sustain such dividend payouts in the future, due to the fact that the company is using a smaller percentage of earnings to reinvest in company growth. Therefore, a stable dividend payout ratio is commonly preferred over an unusually big one. A good way to determine if a company's payout ratio is a reasonable one is to compare the ratio to that of similar companies in the same industry.

Dividends Per Share

Dividends per share (DPS) measures the total amount of profits a company pays out to its shareholders, generally over a year, on a per-share basis. DPS can be calculated by subtracting the special dividends from the sum of all dividends over one year, and dividing this figure by the outstanding shares. For example, company HIJ has five million outstanding shares and paid dividends of $2.5 million last year; no special dividends were paid. The DPS for company HIJ is 50 cents ($2,500,000 ÷ 5,000,000) per share. A company can decrease, increase or eliminate all dividend payments at any time.

A company may cut or eliminate dividends when the economy is experiencing a downturn. Suppose a dividend-paying company is not earning enough; it may look to decrease or eliminate dividends because of the fall in sales and revenues. For example, if company HIJ experiences a fall in profits due to a recession the next year, it may look to cut a portion of its dividends to reduce costs.

Another example would be if a company is paying too much in dividends. A company can gauge whether it is paying too much of its earnings to shareholders by using the payout ratio. For example, suppose company HIJ has a DPS of 50 cents per share and its earnings per share (EPS) is 45 cents per share. The payout ratio is 111% (0.50 ÷ .45); this figure shows that HIJ is paying out more to its shareholders than the amount it is earning. The company will look to cut or eliminate dividends because it should not be paying out more than it is earning.

The Dividend Discount Model

The dividend discount model (DDM), also known as the Gordon growth model, assumes a stock is worth the summed present value of all future dividend payments. This is a popular valuation method used by fundamental investors and value investors. In simplified theory, a company invests its assets to derive future returns, reinvests the necessary portion of those future returns to maintain and grow the firm, and transfers the balance of those returns to shareholders in the form of dividends. According to the DDM, the value of a stock is calculated as a ratio with the next annual dividend in the numerator and the discount rate less the dividend growth rate in the denominator. To use this model, the company must pay a dividend and that dividend must grow at a regular rate over the long-term. The discount rate must also be higher than the dividend growth rate for the model to be valid.

The DDM is solely concerned with providing an analysis of the value of a stock based solely on expected future income from dividends. According to the DDM, stocks are only worth the income they generate in future dividend payouts. One of the most conservative metrics to value stocks, this model represents a financial theory that requires a significant amount of assumption in regard to a company’s dividend payments, patterns of growth and future interest rates. Advocates believe projected future cash dividends are the only dependable appraisal of a company’s intrinsic value.

The DDM requires three pieces of data for its analysis, including the current or most recent dividend amount paid out by the company; the rate of growth of the dividend payments over the company's dividend history; and the required rate of return the investor wishes to make or considers minimally acceptable.

The current dividend payout can be found among a company's financial statements on the statement of cash flows. The rate of growth of dividend payments requires historical information about the company that can easily be found on any number of stock information websites. The required rate of return is determined by an individual investor or analyst based on a chosen investment strategy.

The DDM can be adjusted to accommodate companies with fluctuating dividend payments, assuming there is a stable long-term dividend growth rate at some point in the future. This method is known as the multistage DDM or the unstable DDM. With this valuation method, investors must estimate the value of individual future dividend payments and discount each of those payments to present value. Once the future dividend rate becomes stable, the regular DDM equation can be applied to future payments, and the value from this equation is discounted to present value in the same manner as the irregular payments. The multistage model is limited in that it ultimately requires a stable dividend growth rate in the future, and it assumes changes in rate in the irregular periods are immediate.

While the dividend discount model provides a solid approach for projecting future dividend income, it falls short as an equity valuation tool by failing to include any allowance for capital gains through appreciation in stock price.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.