A few times now I’ve seen dividend investors claim that paying dividends doesn’t make stock prices drop. The claim is that investors know the dividends are coming and they are already built into the price of the stock. This isn’t true, but perhaps the reason isn’t obvious. After all, this type of reasoning does make sense with other types of news about stocks.
This is best explained with an example. Consider two companies:
– will be paying a $1 per share dividend tomorrow
– won’t be paying a dividend
– will be paying a fine tomorrow that works out to $1 per share
In both cases, we assume that investors have known about these facts for a long time. In company B’s case, when tomorrow comes and they have to pay the fine, their stock price changes no more than usual because investors have known about the fine for a long time and have already factored it into company B’s share price.
So, the question then is why doesn’t this logic apply to company A? After all, their situations look quite similar. But, when company A’s shares trade ex-dividend (meaning that the share buyer won’t get the dividend), the share price drops by $1. Why the difference?
The answer comes from examining exactly what investors are buying today versus tomorrow. In company B’s case, if I buy today and hold until tomorrow I’ll have the same thing as if I wait until tomorrow to buy. In both cases I’ll have shares of a slightly poorer company B.
In company A’s case, if I buy now and hold until tomorrow I’ll have the slightly poorer company A plus a dollar per share. If I wait until tomorrow to buy company A’s shares, I won’t get the dollar per share. So, company A’s shares are more valuable to me today than they will be after the dividend gets paid.
A factor that makes this difference less obvious is that dividends amounts are usually small compared to stock prices. The natural volatility of stock prices masks the share drop caused by paying the dividend.
Another factor masking this effect is that most dividend-paying companies have enough earnings to justify their dividends. So their profits make their shares more valuable over time. This means that share prices tend to build up through each quarter as profits are earned.
If we could remove the market’s volatility, we’d see a saw tooth pattern with share prices rising steadily for 3 months and then dropping suddenly when the dividend is paid. But market volatility and investor behaviour mask this pattern.
Don’t get caught up in magical thinking. You can’t take money out of a piggy bank and expect it to still hold the same amount.