Stocks Drop for Expected Dividends, Not All Dividends

by JT McGee

Stocks often drop in value equal to a dividend when the ex-dividend date passes. The reason for this is obvious: stocks are valued as a going concern (future earnings of the business) plus the current cash on the balance sheet.

A business is worth $.50 less per share if it has $1 in cash on the balance sheet rather than $1.50. Makes sense, no?

One thing I want to make clear is that stocks don’t drop perfectly in response to a dividend, especially if the dividend is unexpected.

Discounting Cash

One of the dangers of investing in a company is taking cash at its face value. I always discount the cash a company has because you never know when that cash will be returned to you. For example, Apple has a $137 billion cash horde, but if it comes back to shareholders 10 years from now it’s only worth $.39 on the dollar if you want a 10% annual return.

If it comes back 5 years from now discounted at 10% per year, one would need to pay $.62 on the dollar for all that cash to get the required return. In short, cash is cash, except when it is stuck as cash for a very long time.

So, if a company pays out a special or unexpected dividend, it is likely that the stock will drop by less than the amount of the dividend. Case in point: Conrad Industries, a stock pick for 2013. While it is mostly illiquid, it does have a good number of active value investors behind it. The company paid a $2 dividend per share before the end of 2012 (thanks!), and the stock price went nowhere.

You could make the case that this had mostly to do with liquidity, but I would say it had to do with:

  1. Expectations – Conrad Industries has a lot of working capital, probably too much. Investors have no real expectations for this coming back any time soon, and no real way to know when it will be paid out to shareholders in the form of dividends or repurchases. Thus, I expect most investors to have discounted it significantly.
  2. The qualitative – A large special dividend from a company 100% controlled by a single family is a good indication that the controlling family will still act in the best interest of shareholders. This positive effect could easily overcome the valuation change when $2 of cash per share was removed from the firm. Remember, good management that acts in the interest of shareholders is everything!
  3. Changing leverage – Investors in the stock market want businesses, not bank accounts. Removing cash from the balance sheet increases the extent to which the stock is tethered to the performance of the business, not the retained earnings that are sitting around doing nothing.

Not specifically in this case, but in other cases dividends aren’t priced in because:

  1. Dividends attract new investors – A higher dividend yield can bring new investors to the table. The threshold now is 3-4%, roughly twice the 10-year Treasury yield. Bringing in a new class of shareholders brings in a new source of demand for shares. Furthermore, the possibility for rising dividends leads to a new way to value a company (dividend discount model), which can lead to more aggressive price targets.
  2. Pricing in a dividend is really just nonsense - Sorry, guys, but a $.05 dip after hours on a $12 stock because of a dividend payment is really kind of silly. That kind of price action just gets lost in the next quarter of trading, in which a nickel is really not signficant. (If you buy a stock because you think it’s .5% undervalued…well, you’re doing it wrong!)

It’s not ever simple enough to say that a stock will drop in value in the amount of the dividend. There are a number of companies, especially companies in the tech space, which I think would earn much higher valuations in terms of dividends + share prices if they were to do a dividend recapitalization by borrowing cheap to return overseas (untaxed) dollars to shareholders. Some of these include Apple, Cisco, Oracle, and Google.

So, in short, stock prices do not always dip in response to a dividend. Share prices respond to an expected dividend, but rarely to an unexpected dividend because cash on the balance sheet is often valued in investors’ minds at less than reported…unless it is returned.

{ 3 comments… read them below or add one }

Money Beagle January 31, 2013 at 13:45

The dividends and the effect on cash flow are just one of many factors that would dictate the impact on stock price. One example is that a company can announce a dividend, yet if investors feel that they are taking cash away from necessary R&D, they can see a threat to the long term sustainability of the company compared to its competition, and it could get punished. You never know what the market really wants but it’s always interesting to watch the reactions and such.

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PK February 1, 2013 at 11:26

However, that doesn’t necessarily mean you can predict the reaction to a dividend payment ahead of time. If one stock consistently dropped less than the dividend payment, some big fish could come in and arbitrage the advantage away.

And if a big fish didn’t, I would.

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William @ Drop Dead Money February 6, 2013 at 13:07

Good point. I invest in REIT preferred stock, which has a predictable quarterly dividend. The price therefore doesn’t move much, and so it’s clearly discernible when the ex-dividend date rolls around – an immediate 50 cent drop. Beforehand, it’s a little more gradual.

I think you’re right that dividends, to be effective, have to be expected. A random distribution doesn’t do the company any good, because stock prices in general are based on expectations more than anything else….

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