When a company pays a dividend, the value of the company drops by the amount of the dividend. This fact can be difficult to observe for companies that pay small dividends, but you should be able to clearly see it in companies with big dividend yields, such as real estate investment trusts.
One way to think about a company's value is that it is equal to the value of earnings in the future plus the value of the assets that aren't needed to run the daily operations.
Valuing a company
Let's assume that a company produces $3 in annual earnings per share. Based on the strength of the company's business model, and the valuations of competing businesses, the market may value this stream of earnings at 10 times earnings, or $30 per share.
The company has been profitable for years and has slowly built up a stockpile of cash that sits on its balance sheet. This cash is excess that it doesn't need to fund its daily operations. It sits idle, perhaps in a savings account, or in the form of short-term U.S. Treasury securities. Assume this cash amounts to $5 per share.
One might value the company at $35 per share. The earnings produced by the productive assets ($3 per share, per year) are given a multiple of 10 times earnings, or $30 per share. The excess cash is worth $5 per share. Add it up, and you get a valuation of $35 per share for this company.
Suppose the company has decided that keeping $5 per share in excess cash really isn't the best way to run the business. In fact, it thinks it should simply pay out $4 per share in cash as a special dividend to shareholders and retain only $1 per share in cash as a corporate "rainy day" fund.
On Dec. 1, 2015, the company declares the $4 dividend per share, noting that it will pay this dividend to shareholders who own the stock on Dec. 11, also known as the record date.
Based on the information we have, we know that shareholders of record on Dec. 11 will receive the dividend. In the United States, stock transactions take three business days to clear. Thus, to be a shareholder of record on Dec. 11, you would have to buy the stock on or before Dec. 8.
On Dec. 9, the stock will go "ex-dividend," meaning that anyone who buys the stock on or after Dec. 9 will not receive the dividend. On this day, you can expect the stock to drop by the amount of the dividend ($4 per share).
The logic is as follows:
On Dec. 8, the company trades for $35 per share. The future earnings are worth $30 per share, the soon-to-be paid dividend is worth $4 per share, and the excess cash after the dividend is paid is worth $1 per share.
On Dec. 9, the company will trade for $31 per share. The future earnings are still worth $30 per share, and the excess cash is still worth $1 per share, but anyone who buys the stock on this date or after will not receive the dividend of $4 per share payable on Dec. 11. (In this case, Dec. 9 is known as the ex-dividend date because it is the date at which a buyer of the stock will not receive the dividend. The stock trades at a price excluding the dividend, hence the term "ex-dividend.")
Put simply, on the ex-dividend date, the company is theoretically worth the previous day's closing price minus the upcoming dividend per share.
Your broker should provide you with the relevant dates for when a company declares, records, and pays a dividend. It should also provide an "ex-dividend" date for stocks you own. Pay close attention to how a stock trades on ex-dividend date. The larger the dividend as a percentage of the share price, the more likely the stock goes down in value on that date.
Want to start investing? The Motley Fool's Broker Center can help you find the best broker for you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.