If you are a shareholder, your bank account statement would often be dotted with deposits from companies you have invested in. These are a portion of profits that every listed company distributes to its shareholders. The idea is to give back to investors who trusted the company and helped it grow-like a small return gift at the end of a party.
But as investors, did you know dividends also affect share prices?
In the stock market, prices of shares fluctuate every second. So how do you—or experts—know which is the right price to buy? Analysts use different models to identify the right price. One such model is based on dividends. It believes that the right price should be the ‘present value’ of all future dividends. So, higher the dividends, greater will be the share price. However, in India, companies prefer to reinvest their profits to grow the business; they only distribute a small portion of their profits to investors.
In India, share prices usually rise a short while before the company announces dividends. Once the dividend has been distributed, the share price plummets almost immediately. The quantum of the fall is usually equal to the amount of dividend announced. So, for example, if a company distributes dividend worth Rs 100, it’s quite likely that the share price too falls by a similar amount the day after distribution. This is called the Ex-dividend price.
Not every stock market investor has the same strategy to make money. Some prefer to buy and hold for years and decades. Some want to make profits over the short term. One such short-term strategy is to ride the Dividend rally. Such investors and traders buy shares of a company a month or so before the dividend distribution. This effectively drives prices higher. Once they receive the dividend, the investors sell the shares. On paper, this leads to a capital loss, which is good for tax purposes.
Some investors prefer another dividend-related strategy. They invest specifically in companies that announce high dividends. However, dividends cannot be compared directly. It has to be decided keeping in mind the share price. After all, Rs 10 is a paltry sum for a company ‘A’ with a share price of Rs 1,000; it could be a big amount for a company ‘B’, whose shares are priced at Rs 50. This is why analysts use Dividend Yield to compare dividends. It can be calculating by dividing the dividend amount with the share price and then multiplying by 100. So the dividend yield is 1% for the company A and 20% for company B.
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