At its most basic level, a share represents partial ownership in the future profits and assets of a company.
As we noted in a recent post, companies have three main ways to use surplus cash flows:
- Reinvest those profits back into the business.
- Return profits in the form of a dividend.
- Return profits in the form of a buyback.
Today we are going to focus on dividends. We will show how payment of a dividend affects share prices and look at what kinds of companies are more likely to pay dividends.
Chart 1: A company’s aim is to earn profits, which they can reinvest or return to shareholders
Dividends reduce a company’s assets — that should impact prices too
It’s often said that a share represents partial ownership in the future profits of a company. Paying a dividend doesn’t explicitly change future profits. But it definitely reduces the net assets of the company — by an amount exactly equal to the dividend.
Which raises a question: How much does paying a dividend change the value of a company and, therefore, the company’s stock price?
Getting to ex-date
Each time a company pays a dividend, there are a few important dates to keep track of as we show in Chart 2.
For investors, the ex-dividend date (ex-date for short) is the most important. That is the date when buyers of the stock no longer receive the pending dividend. Because of that, it’s also the date the company’s share price adjusts to account for the dividend payment.
In short, an investor buying the stock:
- Before the ex-date will be settled and “on record” in time to be paid the dividend.
- On or after the ex-date won’t be on record in time, and so they won’t receive the dividend.
Chart 2: Dividend timeline
Although, those who had bought prior to the ex-date still need to wait until the actual pay date, when cash dividend payments are actually distributed, to receive the cash.
This can cause “cash drag” in a portfolio, especially if the market appreciates while the portfolio is waiting to receive the cash, as it can’t “reinvest” the dividend in other stocks without leveraging the fund.
In practice, many professional investors will buy exposure for (or cover) these cash accruals using futures, which don’t require cash settlement but still give broad stock market exposure.
What happens when a stock pays a dividend?
In theory, an investor should be willing to pay less for a stock that doesn’t come with the dividend – compared to one that does. And, given the dividend is paid in cash, the difference in valuation is simple to calculate. Intuitively, a stock should fall by the exact amount of the dividend as it goes ex-dividend.
- The opening trade of ex-date is the first time the stock begins trading without the right to receive the upcoming dividend.
- The closing trade before is the last time the stock begins trading with the right to receive the upcoming dividend.
- So, comparing the opening price to the prior closing price should give us the most precise estimate of the dividend impact (as opposed to looking at closing or intraday returns).
Using a real example (below), we try to visualize the ex-dividend impact on PepsiCo’s (PEP) stock around its December 2024 ex-date. We see that the price of PEP did in fact fall overnight as it went ex-dividend (blue line in Chart 3).
Chart 3: PepsiCo (PEP) vs. Coca-Cola (KO) on Dec. 6, 2024
In this case, we see the price-reaction of Pepsi’s stock (PEP, blue line) around ex-date:
- The ex-date is Dec. 6, with a dividend payable of $1.35 per share.
- The stock price fell from $160.49 (at the end of Dec. 5) to $159.35 (at the start of Dec. 6).
- That’s a drop of $1.14 ($0.21 less, or better than, than the dividend).
- The return including the dividend ($0.21) equates to a positive return of 0.13%.
A lot can happen overnight, such as market news, company news and changes in market sentiment. That can make the close-to-open performance differ by more or less than the dividend.
So, the obvious next question is: Was there some positive news that helped boost the ex-dividend stock to account for that 21 cents difference?
Given PepsiCo and Coca-Cola are both in the same industry and usually have high positive correlation (~0.70), we can “control” for the ex-dividend impact by comparing KO to PEP.
The fact that KO (red line) traded higher between the close on Dec. 5 and the open on Dec. 6 seems to indicate that there may have been some positive news, or sentiment, about the industry overnight. In fact, KO was up around 0.30% in the pre-market session, prior to opening about flat.
In short, both KO and PEP experienced positive overnight returns of a similar magnitude (after including the dividend). It seems possible the “real” price adjustment was very close to equal to the dividend.
Does the market always discount the whole dividend on ex-date?
Using a similar approach, we compare the adjusted overnight return to the dividend paid for all U.S. large-cap equity securities over the past five years (January 2020 through December 2024). Although for simplicity, we adjust by the market return (instead of a well correlated pair).
The data shows that on ex-dividend dates:
- Many stocks see their prices fall by roughly the value of their dividend.
- Although the median stock declines by only around 90% of its dividend amount.
- The most likely outcome is a drop even less than that.
- A reasonable percentage (~20%) of stocks see prices increase on ex-dividend date — even after accounting for the market moves overnight (grey zone in Chart 4).
Chart 4: Distribution of ex-dividend price reactions (U.S. large caps)
Some stocks fall by much more than the dividend, too (after adjusting for market performance), showing that many other impactful things can happen overnight.
What types of companies pay dividends?
Not all companies pay dividends. For a start, it’s hard to justify dividends when a company has good growth opportunities that need reinvestment of cashflows.
Not surprisingly then, the data shows that larger (more mature) companies are more likely to pay dividends (Chart 5). The same goes for more value-oriented companies — remembering that value is typically defined as companies with stronger earnings yields and lower rates of growth.
Chart 5: Characteristics of dividend-paying stocks
We also see that companies that are included in more defensive industries, such as utilities, financials, materials and staples, tend to pay dividends more than peers in industries like technology, health care, or telecommunications (Chart 6, green bar).
Although that doesn’t always translate to a higher dividend yield coming from those companies (blue dot). In fact, the highest yields tend to come from real estate, utilities and telecoms.
Chart 6: Dividend-paying stocks across industry
What this all means
Investors who require a regular income stream are more likely to care about receiving dividends. While investors looking for higher growth companies may need to accept mostly price appreciation and capital gains.
Regardless, if you are investing in shares, it pays to keep track of the ex-dates. And if you see an abrupt drop in price on the ex-date, it might not be bad — it might just be the dividend adjustment.
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