investing

Dividends' Effect On Short Term Stock Prices

January 16th, 2015

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

If you take a look at around the personal finance blogosphere (This linkshows you a list of blogs), you'll see that almost everybody likes dividend stocks. Some of the bloggers who invest based on dividends include 'The Million Dollar Journey', 'Boomer And Echo', 'Young And Thrifty', and many many more. Some blogs even have the word 'Dividend' right in their names!

To be sure, I don't have anything against these bloggers for choosing to invest in dividend stocks. In fact, I like some of the blogs I mentioned. However, I don't think their investment strategy is wise.

Bloggers aren't the only ones entranced with dividends of course. Even my dentist asked me whether I thought he should get into dividend stocks. I know plenty more people who had the same question.

Here's the thing. As a value investor, nothing raises a redder flag than a 'popular' investment.

In this series, I'll explain how dividends affect the true value of stocks. As you'll see, dividends are not great for stocks.

What Are Dividends?

You may already know that stocks are part ownerships of companies. In the beginning of a corporations life, investors put their money into the corporation, and received stocks in return for their investments.

Investors are not charities; they demand a financial return for the risk they took by investing in such corporations. Usually after they start generating profits, a corporation can distribute some of its cash to their shareholders to reward their shareholders. This distribution is called a dividend.

Unlike with a bond, the corporation doesnt have to pay dividends regularly .They can cut dividends anytime they want, without any legal consequences.

The amount of dividends paid as a percentage of the value of each share is called its dividend yield. For example, if a corporation pays $1 every year, and its stock price is $20, then the yield is $1/$20 = 0.05 (i.e. 5%).

How Dividends Affect Stocks In The Short Run

Theoretically, it shouldn't matter whether a company pays a dividend in the short run.

If a corporation pays out $1 in dividends per share, then the 'true value' of that share goes down by $1. That's because the corporation holds less cash, and so it's worth less.

This works in practice too.

To see why, lets examine what happens right before and after the "ex-dividend date". Corporations pay dividends to those who held shares at the end of the ex-dividend date. So if you want to receive the dividend, you must buy shares before that date.

Lets take an example. Lets say Corporation XYZs share is priced at $20, and pays $1 every year. The ex-dividend date is tomorrow. If you hold XYZs shares through tomorrow, youre entitled to receive the $1 in dividend.

Now, I have a pop quiz - what will happen to the price of XYZ shares tomorrow?

The answer: it will go down by $1, to $19. It has to be that way. If XYZ shares were to stay at $20, you would have earned $1 with no risk. In that case, guys with lots of money will come in and buy a bunch of XYZ shares, driving XYZ stock prices up. The next day, they will dump XYZ shares, driving prices down. They will do this until the difference between the prices of shares today and tomorrow is exactly $1.

On the other hand, if XYZ didnt pay any dividends at all, the stock would stay at $20 tomorrow. So if XYZ paid dividends, then youd have $1 in your pocket + $19 in stock. If not, youd have $20 in stock. In other words, theres no difference.

The Silliest Thing I've Ever Heard

If a corporation has cash, it can always pay dividends. However, some dividend investors have completely missed this point. Take a look at this articlein Forbes, of all places. Let me quote you an excerpt.

For a stock that pays no dividend, an investor requires what is known as a "greater fool" in other words, someone else who is willing to pay more for the stock than you did.

This is silly.

Let's say corporation XYZ has $100 million in cash and no debt. It's silly to think that this corporation is worth much less than $100 million. After all, XYZ can declare dividends to the tune of $100 million whenever it wants.

If XYZ trades at just $50 million, do you know what will happen? Some rich investor will come along and buy the company - maybe for $70 million, and pay himself the $100 million in dividends.

In other words, a stock has an objective value regardless of whether the corporation pays any dividends.

Since corporations can choose to pay any amount of their cash in dividends, what's important is not whether the corporation pays dividends. Instead, we should focus soley on the business' cash generation ability. That's the real driver of value.

I hope you enjoyed today's post. In the next installment of this series, I'll explain how dividend stocks became popular in recent years, and why I think the trend can reverse.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.