On February 13, IDFC Ltd’s stock fell a massive 14 percent. One of the reasons cited was the interim dividend of Rs 11 a share the financial firm paid to its shareholders. A dividend is the distribution of profits by a company to its shareholders. Since it is in a way a reward to shareholders for investing in the company, shouldn’t dividends prompt an increase in the share price? Why do stocks fall once a firm pays dividend to the shareholders? Read on to fine the answers.
What does dividend payout mean for a company?
When a company makes profit, it has the choice of ploughing it back into the business for growth or paying it out to shareholders as a reward. World over, companies choose both options intermittently and pay part of the profits as dividend.
In India, companies as a rule reinvest their profits into the business for growth. That said, they also pay dividends to shareholders whenever warranted. When a company pays out dividend, it could either mean it finds no opportunity to reinvest in growth or that it has enough cash to fuel growth. Cash-rich companies typically pay dividends regularly.
Do dividend payouts rob the company of growth?
Not necessarily. Usually, companies adopt a mixed approach by reinvesting part of their profits and distributing the rest as dividend. There is, however, one segment of shareholders that lose out when companies pay dividend. These are investors who buy shares after the company has paid dividend. Essentially, a portion of profits would not be available to them because it has not been ploughed back into the business. To that extent, potential investors have lost out on some of the returns on their stock.
What happens once a dividend is declared?
Companies must declare in advance that they wish to pay dividend to shareholders through a notice to the stock exchanges. The exchange notice contains the amount of dividend and the date of the payout. It also details the time given to new investors to buy the stock if they wish to partake in the dividend. Ergo, the stock price of a firm typically rises if the dividend payout is appealing for investors to buy the stock.
Most of the time the stock gains after the dividend is declared until the payout date. On that date, the stock becomes ex-dividend.
So why do stocks fall after a dividend is paid?
There are multiple ways to look at this. Note that dividend is a distribution of profits and so potential investors who buy the stock stand to lose as they do not get their share of profits either through dividend or through growth.
So the new investors have no incentive to buy the stock. The stock price adjusts to the dividend paid out as opportunity lost and analysts calculate this as the ex-dividend price of the stock. For instance, IDFC Ltd announced an interim dividend of Rs 11 per share and its share price reduced by Rs 13 on the payout day.
Post dividend payout and a fall, is the stock still attractive?
The factors behind the fundamental value of a company’s stock are many and not restricted to its dividend distribution policy. Sure, companies that are regular dividend payers find more support in the equity markets but returns are also a fallout of business growth.
Shareholders may prefer that the firm reinvest its profits for greater returns in future and some shareholders may prefer upfront payment of the gains. The company’s dividend distribution policy must cater to the expectations of a wide range of shareholders. Further, the decision to pay dividend also rests on the firm’s growth prospects, which is an offshoot of economic conditions. In IDFC’s case, the stock derives most of its value from the business of IDFC First Bank while other subsidiaries contribute a small amount to profits. The profitability of the bank and subsidiaries has a direct impact on the returns of the IDFC stock.
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