The Bizarre situation where Share and Stock Prices tend to drop after Dividend declaration can be explained. It is not a myth that Share Prices drop immediately after declaration of Dividends in the Company General Meeting. Many people find it odd that the relation between Dividend and Share Prices is Inversely Proportional. Normally, if a company is declaring dividend, it a very good new to the share holders. They why does the share prices drop after the declaration of current year Dividend.
Reason why Share Prices Drop After Dividend
There are two reasons for this:
- The Dividend does not meet the expectation
- Due to Ex-Dividend Concept
Not Meeting Expectations
When the dividend payout ratio does not meet the expectations of the shareholders, heavy selling goes on for hours, which will lead to fall in Share Prices.
For example, In 2011, an unnamed company declared dividend at 11.30 AM, and by 2.00 PM the share prices of that company has dropped down by $5.00
To under stand why share prices drop after dividend declaration, you may need to first understand the concept of Ex-Dividend. Ex-dividend is a concept where, when you buy a company’s share, you will not have right for its dividend.
For example, there is a share you can purchase today that will pay you a Dollar tomorrow. That means the share is worth at least a dollar more today than it will be tomorrow. Why because, Purchasing it today will mean you will make a dollar 100% guaranteed the next day, and purchasing it tomorrow will be too late. Therefore, the price to purchase this will be a dollar more than it will be tomorrow.
In economics, this is called arbitrage. It states that there are no free profits. Can you imagine if stocks didn’t fall after issuing a dividend? You could simply purchase all the stocks issuing a dividend the next day, and make infinite money with zero risk.
When the company pays the dividend, the share price is reduced to accommodate the ex-dividend rate.
In many cases companies that give high rate of dividends are the ones that do not have much growth potential anymore, that’s why they opted to pay out high dividends from their earnings rather than using those earnings to reinvest to grow their business. These are usually established companies that are stable. As a business, they usually only stay stagnant or go downhill from there.
It is only half true that Share Prices fall after the declaration of Dividends. In case of large Multinationals, you will not find this fall in share prices. Only shares of smaller companies tend to follow this rule.