How Does a Dividend Payment Affect the Shareholder's Wealth?

How Does a Dividend Payment Affect the Shareholder's Wealth?
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Dividends are cash or stock disbursements that a company pays to investors. Dividends affect shareholders in multiple ways and should be considered when making investment decisions. A cash dividend is money in hand for the investor -- a form of compensation for owning the stock. Companies focused on growth and increasing share value often forgo paying a dividend and instead invest those funds back into the company.

Types of Dividends

Companies traditionally offer dividends in either cash or shares. If a company pays a dividend of 20 cents per share, that means that for each share an investor owns, he will receive 20 cents. An investor who owns 1,000 shares would receive $200 when dividends are paid. When a company offers a stock dividend of 0.20, it means that for each share owned, the investor will receive an additional two-tenths of a share. These partial shares are called "fractional shares." In this case, an investor who owns 1,000 shares would receive an additional 200 shares.

Effect of Cash Dividend on Share Price

When a company pays its investors a dividend, it cannot reinvest those funds in the business. The retained earnings, or value of the company, will decrease by the amount of cash paid out. This is reflected in the stock price. Theoretically, a company that pays a 20-cent dividend will see the share price drop by 20 cents.

Effect of Share Dividend on Share Price

Share dividends are paid in additional shares rather than cash. If a company gives a 0.20 share dividend, the number of shares outstanding increases, thus decreasing the value of each share. If a company has 10 million shares outstanding and the share price is $5, the market capitalization of the company is $50 million. When the share dividend is implemented, 12 million shares will be outstanding (10 million x 1.20). Market capitalization will stay the same, but the share price should theoretically move to $4.17 per share ($50 million divided by 12 million shares).

Share Price and Dividend Changes

Anomalies can occur in share prices because of changes in dividend policy. When companies increase the dividend, this may cause a short-term rise in the share price as the dividend attracts buyers to the stock. On the other hand, when a company reduces a dividend, the stock may see a short-term sell-off as investors who hold the stock for the dividend decrease their position. Dividends are often paid by mature companies with low growth prospects.