by Mark Kennan, Demand Media
Investors make money from stocks they own in two ways: selling the stocks when the price goes up and receiving dividends from the shares they own. However, buying right before a dividend and selling right after isn’t usually a way to make money because the market responds to dividend payments by adjusting the stock price for the value of the payment.
When a company declares a dividend, it’s promising to pay investors from its own cash pool based on the number of shares that each person owns. For example, if a company declares a $1 million dividend, that company has to come up with $1 million in cash to make the payments. When the company announces a dividend, it also sets a record date, which is the date you need to be recorded as a shareholder to receive the dividend. Whoever owns the stock on that date gets the dividend payments.
Effects on Stock Price
Because paying a dividend lowers the amount of money a
company is worth, the stock market responds by lowering the price of the company’s shares. For example, say a company is worth $50 million and has 2.5 million shares outstanding. Based on that valuation, an investor would be willing to pay $20 per share. If the company pays a $1 million dividend, or 40 cents per share, the company would still have 2.5 million shares outstanding, but only be worth $49 million. So, after the dividend the market would only value the stock at $19.60 per share.
No Loss for Current Shareholders
Even though the price of the stock goes down after a dividend, current shareholders don’t lose out. Instead, their wealth just takes a slightly different form — it’s split between the reduced share value and the dividend payment. For example, say you owned shares worth $20 each before a 40-cent per share dividend. After the dividend, your stock is only worth $19.60. However, you now have 40 cents in your pocket from the dividend payment. Adding that 40 cent dividend to your share value of $19.60 puts your total worth at $20 — right where you were before the dividend.
Another disadvantage to buying and selling shares in a short period of time is higher tax rates on any profits you might make. Any time you earn a profit from selling stock you’ve owned for a year or less, those profits are taxed at your ordinary income tax rates, rather than the lower long-term capital gains rates. In addition, if you don’t own the stock for more than 60 days during the 60 days before and 60 days after the stock’s ex-dividend date, your dividends can’t be qualified dividends, which means the payment is also taxed at your higher ordinary tax rates.