Dividends are corporate profits distributed to shareholders. Many companies have established dividend policies that stockholders are familiar with and take into account when purchasing a stock. An unexpected change in dividend policy may cause a strong reaction from shareholders, whose increased buying or selling can send the stock price up or down.
Many companies try to attract and reward stockholders by maintaining predictable dividend policies. Because dividends are paid out of corporate profits, dividend policy is tied to company profitability and financial performance. Investors can forecast dividend policy by following company earnings reports and other financial news releases.
Stock Price Reaction
A stock price typically discounts dividend policy changes ahead of time. An unexpected dividend policy change often results in a strong price reaction. When a stock price is based on an anticipated dividend amount, but the actual amount is different, the stock price will have to be adjusted accordingly, up or down.
A dividend increase is always good news because it means more money in investors' pockets. A higher dividend makes a stock more valuable to new investors who are willing to pay more for it. Because stock prices usually anticipate, or discount, future events, an expected dividend increase is likely to be priced in ahead of time. It's when an increase is more or less than anticipated that the stock price may rise or drop on the announcement.
Conversely, a dividend reduction is unwelcome news because it means less cash in investors' pockets and is probably the result of poor financial performance, so the stock is likely to be in decline. Again, its price could rise or fall in reaction to a dividend reduction if the reduction is more or less than expected.
Dividend Elimination and Resumption
Dividend elimination would mean no more income but is often a last resort, a drastic attempt to conserve cash to save the company from losses or even bankruptcy. This often comes after a series of dividend reductions and a long stock price decline. Once a dividend is eliminated, speculators may decide that things are as bad as they can get and can only get better, so they start buying the stock, thereby pushing up the price. A dividend resumption definitely serves as confirmation that a company has survived and turned itself around, so the stock price is likely to rise further on the news.
If a company has not paid dividends in the past and decides to start paying a dividend, the stock price reaction may actually be neutral to slightly negative. The initial dividend is likely to be small -- so that it can be easily increased in the future -- and is not likely to excite investors. Fast-growing companies need to reinvest all the cash they generate back into the business. The decision to start paying a dividend may be interpreted as a sign of slowing growth, which would mean less stock price appreciation in the future, so investors could actually sell the stock on the news, sending the price lower.
- "One Up on Wall Street"; Peter Lynch; 2000