How does dividend affect stock price and derivatives contracts

28 June 2022
6 mins read

Investing in dividend-paying companies is an excellent opportunity to earn a regular income and create long-term wealth. One of the primary reasons is that the stocks of such companies offer a dual benefit to investors by way of both regular dividend payouts as well as share price appreciation.

That said, did you know that the decision by a company to distribute dividends to its equity shareholders is capable of affecting its share prices? Yes, you read that right. There is a correlation between dividends and the share prices of companies. If the question ‘how do dividends affect stock price?’ is running on your mind right now, here’s the answer.

But before we get to the part where we discuss how dividends affect stock prices, let’s quickly take a look at the concept of dividends.

The concept of dividends

The equity shareholders are technically the owners of a company. And as such, they enjoy a claim on the profits of the company. So, when a company generates profits, it distributes it to its equity shareholders by way of dividends.

When it comes to paying dividends, a company need not always pay them out in cash; they can pay dividends out to its shareholders by allotting them fresh equity shares of the company for free. Such a dividend payout is commonly referred to as stock dividends.

Why should you invest in companies that pay dividends?

Below mentioned are a few benefits of investing in companies that pay dividends.

  • Acts as a great source of passive and stable income
  • Opportunity to reinvest the dividend amount
  • Offers tax advantages
  • Increases the rate of compound gains

What is the ex-dividend and record date?

Before we move further, you should know that there are 4 dates associated with divided payment, and each of them has its own significance. However, 2 dates that critically matter are – ex-dividend and record date. Read on to know their meaning, as it will help you better understand the concept of dividends and its impact on securities/stocks.

Ex-dividend Date

The date by which investors should own stock to receive the upcoming dividend is known as the Ex-dividend Date. In simple words, you must purchase stocks before the ex-dividend date to be entitled to receive a dividend.

Record Date

It signifies the date on which a company determines the list of shareholders who are eligible to receive the announced dividend payment.

How does dividend affect share price?

Now that you’re aware of the dividend concept, let’s move on to answering the question ‘how do dividends affect stock price?’ Paying out dividends basically acts as a good indicator of the company’s financial health and success. That said, here are some pointers that clearly show how dividends affect stock prices.

Dividend-paying companies enjoy favourable treatment

Many well-established companies have made it a habit to regularly and consistently distribute the profits that they generate. This portrays their stability and enhances the goodwill and brand value of the company. Investors tend to view such entities in a far more favourable manner than other entities that don’t distribute dividends as often. This consistent dividend paying mechanism of such companies tends to attract even more investors, thereby creating demand for the stock. As more and more investors flock towards the company, the share price witnesses an increase.

Dividend declaration may lead to an increase in the share price

A company, before distributing the dividend out to its shareholders, first makes a public declaration. This declaration includes essential details such as the dividend amount, the record date, the ex-dividend date, and the date on which the dividend is likely to get credited to all the equity shareholders of the company.

Such a public declaration has a high probability of affecting the public sentiment for the company’s stock in a positive manner. As a result of this, more investors might purchase the stock, which in turn may increase the share price. In addition to this, many traders and investors may also buy the stock of the company for the short term in order to be able to capture the dividend issued by the company. Such a move would also work towards increasing the price of the dividend-issuing company’s stock.

The share price drops down on the ex-dividend date

Continuing on from the previous point, if the share price rose when the company declared the dividend, then it would automatically correct itself on the ex-dividend date. This may be because of the fact that any new buyers of the company’s stock on or after the ex-dividend date would automatically become ineligible for receiving dividends.

As the new buyers won’t be eligible to receive dividends, they might not be willing to pay a huge premium for the shares and thus would start quoting lower prices for the shares. This might compel sellers to demand lower prices, which may negatively impact the company’s stock price.

Impact of dividend on futures & options contracts

Many investors believe that the holders of futures and options contracts do not receive any dividend, and they shouldn’t worry about its impact on futures and options prices. However, the truth is that dividend payments indirectly impact the prices of futures and options contracts. For instance – if the dividend announced by the company is Rs. 10, then its stock price will decrease by the same amount on the ex-dividend date, which in turn will readjust the price to absorb the impact of dividend. This is because the share prices directly impact the price of derivatives (futures and options) contracts as they derive price from their underlying asset.

If the dividend amount is more than 5% of the market value of the underlying security, it would be considered an extraordinary dividend. When an extraordinary dividend is declared, the total dividend amount will be adjusted from the strike prices of the options contract. Click here to know more about this corporate action adjustment.

Conclusion

The above-mentioned pointers help you understand ‘how does dividend affect share price?’ and ‘impact of dividend on the futures and options contracts.’ As an investor, you must know that investing in companies that pay dividends has various benefits, such as stable income, tax advantages, and more. However, as mentioned earlier, the smart way to invest in any company is to research thoroughly about fundamentals, vision, mission, past performance, and more before making your investment decision. Now that you know the basics of dividend, click here to know important facts about it.

Disclaimer: This blog is exclusively for educational purposes.