Last Updated on April 26, 2022 by Rational thinking
Why stocks drop on the ex-dividend date can easily be explained, yet many investors find themselves at a loss in understanding why. An investment in any company stems from more than just a profit-making mind, gratitude for which is in the form of a dividend, as a token of appreciation for the trust in the company itself. However, as simple as the concept of dividends may be, it is common to find many investors at a loss. More significantly, many fail to understand what exactly goes on with an ex-dividend date and why the stock price drops.
A stock drops on the ex-date because assets, in the form of cash, are transferred from the company to the owners/shareholders. Money goes from one pocket to another. If your account is taxable, you receive the dividend less taxes.
To understand why a stock falls on ex-dividend date, it is important to understand why dividends exist, how they work and the important dates to keep in mind.
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Let’s break it down right from the beginning:
Coming from the company’s net profit, dividends are typically a reward meant for the shareholders for their investment in the company. It is important for the dividends to be approved by the shareholders and of course the board of directors. As such, a dividend is a transfer from the company to the owners.
Although dividends come from the company’s net profit, a major portion of that profit is kept as retained earnings, meant for the company’s ongoing as well as upcoming engagements. The remaining amount is then allocated in the form of dividends to the shareholders. It might come as a surprise to many, that in order to maintain a healthy track record of paying dividends, some companies keep paying dividends despite an insufficient profit margin.
The frequency of the payout over different rates is set by the board of directors, though they are generally found to be paid at a linear pace like monthly, quarterly, or annually.
Unilever and Walmart are good examples of maintaining dividend payments quarterly. Though there are exceptions like special dividends that are paid out with the regularly allocated dividends, strongly based on improved financial terms and business performance.
Ex-dividend is known to be a stock that doesn’t carry the value of the next dividend. The ex-date is in reference to this concept, as in the day when the stock begins trading without the value of its next dividend.
As mentioned above, the ex-dividend is one business day before the record date of the stock. Anyone buying stock on or after this date does not qualify for the next dividend payment. Thus, it is paid to whomsoever owned the stock a day before the ex-dividend date. When the dividend is transferred from the company to the shareholders, the share price drops accordingly. This is why the share price goes down on the ex-dividend date.
The ex-dividend date relies partially on the record date and the rules of the exchange it’s trading on.
As a company makes the decision of declaring a dividend, the board of directors sets a record date. This is the date that draws a line where a person should be on the company’s record as a shareholder to be eligible for the next dividend payment. As the record date is established, ex-dividend date is also set, following the regulations of the stock exchange on which the stock is trading.
Already well-established companies with predictable profits are considered some of the top dividends payers. The reason being, these companies intend to increase shareholders’ profit as much as general growth.
Sectors like consumer staples, healthcare, pharmaceuticals, etc. are best known for keeping a regular track of dividend payments. Companies listed under Real Estate Investment Trusts (REIT) and Master Limited Partnerships (MLP) designations require detailed and specified dividends payments for shareholders.
As opposed to well-established companies, start-ups and potentially high growth companies in the biotech or technology sectors often do not offer regular dividends due to a lack of predicting profits.
Start-ups are still considered to be in their development stages and hold as much potential for losses as they do with profit. Hence, they may lack enough funds to structure dividends. Even at an early profit-making phase, companies prefer to invest those funds back into their own business for further growth and development before they start handing out dividends.
Whenever it comes to dividends, there is a certain order to which some events and important dates follow. These are crucial to determine who qualifies as a shareholder to further receive a dividend payment.
The day when the company announces the dividends, approved by the shareholders before they are paid, is the announcement date.
To those who don’t know, there is a day when the eligibility expires for dividends. That day is the ex-dividend date or just the ex-date. It is extremely crucial for any shareholder to know the ex-date.
For example, let’s say that a company has established the dividend date to be Monday, November 30, then the shareholders buying stock on or after that day won’t be eligible to receive the next dividend. The goal is to buy the stock one business day before the ex-date. So the shareholders who bought the stock on or before Friday, November 27, will successfully qualify for the next dividend payment.
Record date plays a role in determining the shareholders’ eligibility to receive the distribution. It’s typically a cut-off date set by the company.
The day set by the company when the money is supposed to be credited to the shareholders’ account is the payment date for dividends.
There are many reasons as to which a company pays dividends to shareholders. The interpretations, however, are subject to different implications and investors.
- There is a sentiment of trust attached to both ends of paying and receiving dividends. Dividends by a company can be taken as a token of appreciation for shareholders to invest in the company, depicting trust on their part. This event also put the company in a positive light to honor investors’ trust. In many countries, dividends are treated as tax-free income due to which shareholders’ are known to prefer dividends as short-term gains.
- It’s an obvious interpretation, that a company with dividends of high value can be valued at making good profits with overall good performance. However, this may also reflect that the company may have a lack of better projects that will generate increased returns in the future. This may explain why the company is handing cash to shareholders instead of investing in their own growth and development.
- In an opposing light, a reduction in the value of the dividend of a company with a stellar track record of dividend payment can have the first impression of trouble with the company. Yet, it can very easily mean that the company is simply investing in their own future with possible projects capable of generating higher revenue and promising growth. The decision depends entirely on the company’s management given their plans for investments, financials, and operations. Such a vision also contributes to shareholder’s profit in the long run.
In very simple terms, the reason why ex-date falls before the record date is the way trading stocks are settled. When a trade takes place, the record of that particular trade is not settled for one business day thus it doesn’t show on the record if the stock is bought on or after the ex-dividend date.
If a shareholder’s investment strategy is inclined towards the income, the ex-date really will play a crucial role in planning the trading entries.
But since the stock drops in price almost the same value as the dividend, buying it right before the ex-date doesn’t result in any profits. The same goes for the ones who buy on the ex-date or buy with a discount, as the dividend won’t be received anyway, profits simply won’t exist.
There is no doubt that the ex-dividend does play a significant role in the price of the stock due to its very definition. But a market is impressionable to many factors besides the ex-date.
In many cases, when a stock is considered undervalued, it is normal to find the stock price to be a bid up even if it’s on the ex-dividend date. Similarly, if the stock has a bitter taste to the investor, it would sell more than general compared to just a drop because of ex-dividend.
The practice is very dependent on the perspective of an investor. An investor can buy the stock on the ex-date with complete knowledge of not receiving the next date, but he would still be entitled to the dividend in 3 months in case of a quarterly dividend payment.
Even though dividends are known to be tax-free incomes in many countries, there is a criterion to be considered to hold that status. So yes, it can become a matter of concern even though most corporate dividends hold a green light and hence are taxed at a special rate, an investor still has to hold a stock for over 61 days to earn that status.
The investor will then face taxes on the first couple of dividends at the normal income tax rate. So if an investor plans to trade stocks right before and after their ex-dates, he or she will probably be in for a larger tax bill and that doesn’t even include the commission to be paid every time one buys and sells a stock.
- Taxes and compounding
- Dividend investing: The marginal rate of return – the incremental rate of return
Why stocks drop on the ex-dividend date – conclusion
Stocks fall or drop on the ex-dividend date. But why does the share price drop on the ex-dividend date? It drops or falls because the dividend is transferred from the company to the shareholders, thus making the company worth less. It’s quite logical. Capital is transferred from the company to the shareholders.
Before entering the stock market or trading in dividends, it is important for an investor to understand the terms of dividend payments and keep in mind the importance of ex-dividend and record date.
Moreover, dividends should be understood more as a distribution rather than an income as they tend to drop by almost the same value as the dividend itself. A dividend is just a capital transfer from the company to the shareholders. That’s why stocks drop on the ex-dividend date.