Understanding Dividend Changes When Stock Prices Drop

Many investors and financial analysts often confuse the concept of dividends with the dividend yield. In this article, we will clarify these concepts and explain why companies do not typically raise dividends when their stock prices drop. Instead, the dividend yield increases as a direct result of the stock price decline. Additionally, we will explore the reasons behind dividend increases and the impact of dividends on stock prices.

Dividends vs. Dividend Yield

A dividend is a cash payment made by a corporation to its shareholders, usually as a return on their investment. Dividend payments are typically declared and fixed amounts per share, independent of the stock price. However, the dividend yield, which is the annualized dividend amount divided by the stock price, can fluctuate based on the stock price.

Example of Dividend Payments and Yield

Consider a company whose stock is valued at $100 per share and has been making a quarterly dividend payment of $4 for the past year. The dividend yield in this case is 4%. If the stock price drops to $80, the last $4 dividend payment remains unchanged, increasing the yield to 5% since the yield is calculated as the annual dividend divided by the new stock price.

Note that a company rarely raises the dividend payment simply because the stock price has dropped. In such cases, the dividend yield increases as the stock price decreases. Conversely, if the company does raise the dividend, the stock price may go up, leading to a decrease in the dividend yield.

Why Companies Raise Dividends

Companies generally increase their dividends when they believe their company's present and future cash flows are adequate to support the higher payout. This action can have several motivations, such as:

Signaling to the market that the company has strong financial health and is doing well. Attracting and retaining investors who value a consistent dividend stream. Improving a company's image and reputation among shareholders. Boosting investor confidence and potentially enhancing stock performance.

It's important to note that a company's decision to raise dividends is independent of its stock price movements. Instead, such increases often have the effect of driving the stock price up, which in turn causes the dividend yield to decrease.

Impact of Stock Price on Dividends

When a stock price drops, the dividend yield naturally increases as the yield is inversely related to the stock price. This relationship can be understood through the following example:

Example: EMD Stock

Consider the example of EMD stock, one of the author's favorite due to its monthly dividend payments. EMD currently trades at $13 per share and pays a dividend of $0.10 per share per month. This amounts to an annual dividend of $9.20.

When the stock price increases to $15: $0.10 / $15 $0.00666 per month (which equals $8.00 annually). When the stock price subsequently drops to $11: $0.10 / $11 $0.00909 per month (which equals $10.90 annually).

In both scenarios, the dividend amount per share remains constant, but the dividend yield changes inversely with the stock price. This demonstrates that the increase in the dividend yield is a direct result of the stock price drop.

Conclusion

In summary, companies typically do not raise dividends when their stock prices drop. Instead, the dividend yield increases as the stock price decreases. Dividend payments are fixed amounts per share, independent of the stock price, while the dividend yield is calculated as the annual dividend divided by the stock price. This relationship highlights the importance of understanding the difference between dividends and dividend yields when evaluating a company's stock performance.

If you have more questions about stocks and dividends, feel free to reach out for personalized advice. Understanding these concepts can help you make more informed investment decisions.