Why are people willing to buy a share of stock?
The fundamental approach argues that investors value the dividends the stock will pay. More generally, they value the income from the stock.
Dividends are a percentage of its annual profits that a company pays to its stockholders as income. That percentage is called the stock’s payout ratio.
Well-established companies are more likely to pay higher dividends than smaller or growth-oriented companies that often prefer to use their profits to fund additional expansion.
The value of the dividend has two components. The first is the dividend itself, which, given the uncertainty of its future, entails an educated guess about what the company will declare at some later date.
It is by nature a forward-looking, expected-value calculation that buyers must make.
Buying a stock is riskier, however, than putting your money in the bank. This means that investors will demand a higher average return on stocks to compensate for the greater uncertainty and chance of loss.
Investors assign a lower value to a stock that is expected to pay X % per year than to a bank account that has the same yearly return, because the stock dividend is uncertain. We can express this by saying that the interest rate used to discount the dividend is higher.
This interest rate is the second component affecting the value of the dividend.
The fundamental price of a stock may thus fluctuate for two reasons:
Expectations about dividends may change, or the required rate of return may change. That is, future cash flows may vary, or the way investors value those flows may vary.
It’s common knowledge that slow dividend growth may depress a stock’s price, but it is also true that uncertainty about those dividends or an increase in bond and bank rates can have the same effect.
The Board of Directors decides if it will declare a cash and/or stock dividend and the date associated with it.
How can you try to predict what the dividend will be before it is declared?
Many companies declare regular dividends, so if you look at the last dividend paid, you may be able to guess what the next dividend will be.
Financial listings show the dividends declared by Boards of directors the previous years, along with their dates.
Other companies declare less regular dividends, so try to look at how well the company seems to be doing.
Some companies may not pay dividends on their stock, usually because they have missed payments on their bonds, or because they are not doing well, or because they want to retain the earnings.
Dividends do matter over the long run!
Currently, investors, for the most part, don’t care too much about dividends. That’s a shame since dividends, historically, have mattered greatly to a portfolio’s total-return potential.
When choosing stocks, don’t completely ignore dividend-growth potential!
Indeed, during volatile market periods, the dividend return may be the only return you will ever see!
About the Name “Dividend”
The name comes from the arithmetic operation of division:
A / B = C
A is the dividend, B the divisor, and C the quotient.