Dividends are corporate profits distributed to shareholders. The board of directors has the authority over dividends. Every company has a dividend policy that covers a wide range of issues, from whether to pay dividends to how much. Corporations' boards of directors are aware that dividend policy decisions can have a profound impact on a the price of stock.
Investor Base Expectations
Every company has an investor base --- the types of investors who own the stock for specific reasons. Investors are generally familiar with a corporation's dividend policy and expect it to continue. Knowing its investor base, the corporation's board tries to maintain a stable and predictable dividend policy to accommodate investors. If a dividend policy is implemented as expected, it usually has little impact on a stock price because investor expectations are usually priced into the stock before a dividend decision is made. If a dividend decision is unexpected, however, the buying or selling that results could have a profound effect on the stock price.
Most growth stocks pay little or no dividends because they need to reinvest all the cash they generate back into the business. Investors buy growth stocks for capital appreciation --- stock price increases --- and generally disregard dividends in their calculations, because a growth stock can appreciate 100 percent while paying a 1.0 percent dividend. Actually, if a growth company that has not paid dividends decides to start paying a small dividend, its stock price may begin to decline if investors start selling out of fear that growth is slowing: The company no longer needs all the cash for the business.
Dividend Paying Stocks
Stocks in mature industries with limited growth potential and excess cash flow --- utilities for example --- pay general dividends. Investors buy such stocks for dividend income and expect the dividends to continue. If a company suddenly reduces its dividend, its stock price could decline as income investors flee a stock that is now generating less income.
When a board increases the dividend, shareholders receive more income, so the stock price is likely to increase because the stock becomes more valuable to investors who are willing to pay more for higher income. A 10 percent dividend increase may result in a 10 percent stock price appreciation. Knowing this, some boards try to increase dividends regularly, even by a small amount, to enhance shareholder value. Some investors value dividend growth more than dividend yield: A corporation's dividend may yield only 2 percent or 3 percent, but regular dividend increases would help its stock price.
If a corporation's profits decline, dividends become unsustainable and must be cut to conserve cash. Stocks of companies in financial trouble usually begin to decline before any actual dividend cuts. Dividend elimination after a long stock decline may actually boost the share price because investors welcome the company's effort to conserve cash and start buying the stock on the expectation that the worst is over and the dividend distribution may be resumed in the future as the company's financial condition stabilizes and improves.
- "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
- "One Up on Wall Street"; Peter Lynch; 2000