Dividends Are Not Free Money
One of the most common misconceptions about dividends among new or unsophisticated investors is that a dividend is free money. It is not, yet many uninformed investors scramble to buy a stock before the ex-dividend date in the mistaken belief that they will somehow end up ahead for having done so.
The value of a stock is based on many things, among them the worth of the company's assets. Assets can take many forms, from tangible (buildings, plant & equipment), to intangible (patents, copyrights, brand loyalty, name recognition) and cash. While the value of most other assets can only be estimated, the value of cash (excluding the potential use for that cash) is always known -- it is simply the total amount of cash on the company's balance sheet. Therefore, if you subtract the amount of a company's cash, the company is then worth less, the specific amount less being exactly the amount of cash subtracted.
It doesn't matter if anyone agrees on the value of tangible or intangible assets or the value of its future prospects. Remove the cash from the company and it's worth that exact amount less, because a specific amount of dollars is worth exactly that many dollars.
For example, investor A believes a company is worth $1 million. Investor B believes the same company is worth $700,000. Investor C believes that same company is worth $2 million. When all three investors research the company, the balance sheet shows that it has $200,000 in cash. The company then pays out $100,000 in total dividends. All three investors recognize that although they all have a different opinion on the company's worth, it is now worth exactly $100,000 less than each of them thought it was worth before the dividend was paid. The company's balance sheet now shows $100,000 in cash, so indeed it is worth exactly $100,000 less than it was before the dividend was paid. Strictly simple arithmetic.
To reflect the company's reduced value, before the open of trading on the ex-dividend date the stock exchanges automatically reduce the previous day's closing price quote of the company's stock by the amount of the dividend, calculated by dividing the total amount of the dividend by the number of shares of stock.
For example, the company above paid out $100,000 in total dividends. The company has 200,000 shares of stock, so each share received 50 cents in dividends. Once again, simple arithmetic. $100,000 divided by 200,000 shares equals 50 cents per share.
So, at the opening of trading on the ex-dividend date, the previous day's closing price is reduced automatically by the stock exchange by fifty cents, and trading begins on the basis of the adjusted price. In our example, the company's stock traded at $10.00 on the last trade of the day before the ex-dividend date. That ten dollar closing price was then adusted down by fifty cents before the open of trading on the ex-date and trading begins on an adjusted basis at $9.50.The fifty cent dividend no longer belonged to the company because it was committed to the shareholders, and was no longer available to new buyers of the stock on the ex-dividend date, so that amount was deducted from the stock's price.
Theoretically, and indeed commonly in practice, a stock that traded at $10.00 on the last trade on the day before the ex-dividend date will not open at exactly $9.50, because market forces may drive the price higher or lower, but in any case, the dividend-adjusted price of $9.50 will remain as the basis upon which the daily change is calculated. If, for example, the opening price is $9.00, the daily change at that point will be down $.50. Indeed the price is a full dollar less than the closing price of the previous day, but because of the adjustment for the dividend, in reality the value has changed only fifty cents.
Click Here For a More Detailed Explanation
of What Really Happens to the Stock Price
on the Ex-Dividend Date
The company, and therefore its stock, is worth exactly fifty cents per share less on the ex-dividend date than it was the previous trading day because $100,000 of the company's cash no longer belongs to the company. But keep in mind that while the stock is worth fifty cents less, the shareholders now have fifty cents in dividends, so they have lost nothing. Of course, they have also gained nothing.
So, the idea that dividends are free money is totally without merit. Therefore, those who buy a stock specifically to receive the dividend are mistaken to think they've somehow gained anything. They have not.
If the price
of the stock goes up after the dividend is paid, it may appear to the
unsophisticated
investor that they are ahead for having received the dividend, but the
reality is that it is overwhemingly likely the price of the stock
would've
risen the same amount even if the dividend had not been paid.
After all, retaining cash instead of paying it out to shareholders does
not reduce the value of the company, so there is no reason to believe
that a stock that rises after the payout of a dividend wouldn't have
risen that same amount if the dividend had never been paid.
Another automatic adjustment made by the stock exchange is that at the open of trading on the ex-dividend date, any existing open orders to buy or sell will be automatically reduced by the amount of the dividend to reflect the reduced value of the company, unless they have been placed with a Do Not Reduce restriction. Here is the actual Adjustment of Orders rule: FINRA Rule 5330. Adjustment of Orders
One more important point about buying a stock for a dividend is that although in fact the buyer doesn't gain anything, unless they hold the shares in a tax-advantaged account they become liable for income tax on the amount of the dividend. So, in reality, there can indeed be a downside to buying a stock specifically for a dividend.
There are random occasions where a stock
price opens
up on the ex-dividend date by more than the amount of the dividend or
rises to that point within a few days or weeks and never retreats,
making it indeed
profitable to
buy the
stock before the ex-dividend date. But such circumstances are
rare and no more predictable than forecasting the direction and
amplitude of any stock price.
As opposed to buying a dividend under the false impression it is free money, there are dividend capture strategies that do indeed work an acceptable percentage of the times attempted, but they are employed by relatively sophisticated investors who know that a dividend is not free money. Such strategies exploit the unsteady movement in a stock's price during trading days surrounding the ex-dividend date, often caused by the misunderstanding of dividends by other investors. Another cause of unsteady price movement during such times are the effects of competing dividend capture strategies, which increases the necessary sophistication of such strategies to be successful.
Irrational movement in a stock's price due to the
declaration of a dividend is not uncommon, and is especially true
of stocks that trade with relatively small
volume
or a realtively low stock price, due to such issues attracting a larger
percentage of unsophisticated investors who drive up the price of the
stock
in anticipation of receiving the dividend, thinking it is free money,
when in fact it is not.
Note: While this page details why a dividend is not free money and therefore it is foolish to buy a stock just to receive a dividend, do not confuse that short-sighted act with investing in a company to receive a future dividend stream. While scrambling to buy a stock to gain a single dividend is self-defeating due to the price adjustment on the ex-date, buying a dividend paying stock for the long term can certainly be a viable strategy. A company that pays regular dividends does so because they are constantly earning new income. For example, a company that pays fifty cents per share each calendar quarter will earn at least fifty cents in profits every three months. And because they are earning the amount of the dividend (or more) each quarter, theoretically their stock price should recover over those three months by the amount it was reduced on the previous ex-date, because as the profits are realized, the company is worth that much more. Of course in real life it doesn't always work that way, as stock prices fluctuate in reaction to other events besides dividends declared, but over time that is generally what happens. In any event, consistent earnings that fund consistent dividends can be a very good reason for buying a stock and in ideal circumstances a dividend paying company will, over time, increase its earnings and in turn increase its dividend. So, while buying a stock for a single dividend is almost always foolish, buying a stock for a consistent dividend stream is not.
In conclusion, buying a stock before the ex-dividend date simply to capitalize on the (false) idea that a dividend is free money is nothing more than a beginner's mistake.
Click Here To Read Owner vs. Owner Of Record:
At What Point Do You Become The Owner Of A Stock?
Click Here To Read Dividend Dates FAQ
Click Here To Read An Explanation of Prorated Dividends
Click Here To Read What Are Special Dividends?
000001 TS @ BD +3; 10.15.17
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DEFINITIONS
Business
Day
A day on which the stock exchanges and
the banks, agencies & depositories for securities in New York State
are open
for business. Any day on which the stock exchanges are open but the
banks are closed is not counted as a business day for the purpose of
calculating dividend ex-dates.
Conditional Dividend/Distribution A dividend or distribution conditional upon an event or circumstance that has not yet happened at the time of declaration.
Declaration Date The date a dividend is declared by the company. The amount of the dividend is also declared except in some cases of a conditional dividend.
Deferred
Ex-Dividend Date
An ex-dividend
date that occurs
one business day after the payment date.
Distribution
The payment of cash or securities that are not part of a company's
earnings.
Dividend
A payment of earnings to shareholders.
Due Bill
A statement of money owed.
Ex-Dividend/Distribution Date The first day on which a stock trades without the right to receive the dividend/distribution.
Normal
Dividend/Distribution
A dividend/distribution amounting to less than 25% of a
company's
net worth.
Owner
of record
The registered owner of a
security on
the Record Date.
Payment Date
The day the dividend payment
is
made.
Record Date The day a buyer of a stock must be the registered owner (owner of record) to receive a dividend.
Special Dividend A dividend that is not regularly scheduled.
T+2 Settlement
Rule
The requirement that securities transactions be settled in two
business
days.. (Before September, 2017, securities transactions were
settled in three business days. Before June 7, 1995, securities
transactions were settled in five business days.)