I’ve noticed that some dividend investors try to buy dividend stocks just before the companies make a payment. In reality, there is no advantage to this. To see why, it’s important to understand the mechanics of how dividends are paid and how dividend payments affect stock prices. What really matters is buying dividend stocks when they’re attractively priced.
A number of years ago, I analyzed an unlisted company that was trying to raise cash from private, retail investors. The company was promoting a new tequila brand, claimed huge growth potential, was currently loss-making, and the management team had a big equity stake.
There were many red-flags about the company, but one particular one is relevant for today’s topic. Part of the investment pitch was that investors would receive a hefty dividend payment almost straight away, around 4% a year if memory serves.
Because the company was meant to be raising capital for expansion, it made little sense to me that it would pay an almost immediate dividend. Investors were paying cash to get a small amount of it back in the near future. If the company really needed money for expansion, why not raise less capital, pay no dividend for a while, and let investors keep more cash in their pockets in the first place (instead of recycling it to them)?
(At the same time, the management team – which owned a lot of unlisted stock – could line its pockets with the extra dividend income until the cash ran dry…irrespective of whether the company was a success in future.)
The key point here is that there’s no point in doling out cash to get it right back in the near future. Understanding this gets to the point of when is the best time to buy (listed) dividend stocks.
I’ve noticed that some dividend investors buy those stocks just ahead of when investors will get the next dividend. The idea is to maximise dividend income, which sounds sensible enough on the face of it.
But, in fact, the timing of the next dividend payment, in relation to when a stock is bought, should make no difference to results. In fact, if the income is taxed, it could even leave the investor worse off.
The key to understanding this is around the process of dividend payments, and how they affect the stock price along the way. Each time a stock pays a dividend, there are four dates that are relevant:
- Declaration date (or announcement date)
- Ex-dividend date (or ex-date)
- Record date (or date of record)
- Payment date
The declaration date is simply when the company announces how much it will pay per share. At the same time, it will announce the other dates, in particular the record date and the payment date.
The record date is the day when it’s decided who gets the next dividend. Those that qualify are the registered shareholders – owners of the stock – the day before the ex-dividend date, which I’ll explain in a minute. The record date is usually a few weeks after the declaration date, although it can be longer, depending on the company and the market.
The payment date is the actual day when the relevant shareholders receive cash dividend payments into their brokerage accounts. This is usually a few days after the record date, although I’ve seen situations where it can be a few weeks later.
That leaves the ex-dividend date, number two on the list in terms of the sequence. Depending on the market, this is usually a day or two before the record date. It’s what happens on this day that’s crucial to understanding why timing purchases, just in order to get the next dividend, offers no advantage to the investor.
This quote from the US Securities and Exchange Commission sums it up well: “If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend.”
In market lingo, in-between the declaration date and the ex-dividend date, the stock is described as “cum-dividend”, meaning “with dividend”. At that point, an owner or buyer of the security is entitled to receive the latest dividend that’s been declared but not yet paid. That’s until the stock goes “ex-dividend” (meaning “without dividend”) which happens on the ex-dividend date.
This means, between one day ahead of the ex-dividend date and that date itself, the status of new buyers of the stock switches from getting the dividend to not getting it. Given this, and all other things being equal, this means the stock price will fall by the amount of the next dividend payment on the ex-dividend date.
Let’s say a company declares, on 5th August (the declaration date), that the next dividend per share (DPS) on its common stock will be $2. It will be paid on 23rd August (the payment date) for shareholders of record on 20th August (the record date). In the market where the stock trades, it will go ex-dividend one day before the record date, on 19th August.
If the cum-dividend market price of the stock is $99 on 18th August, then investors should expect it to fall to $97 on 19th August, when it goes ex-dividend. That’s a drop of $2, being the DPS amount, since new stock buyers will no longer qualify to receive that cash income.
This means buying immediately before or after the ex-dividend date makes no significant difference to the investor. They can pay $99 on 18th August and get back $2 on 23rd August, for a net outlay of $97. Or they can buy the stock on 19th August for $97, which is the same net amount.
Of course, stock prices rarely fall by exactly the amount of DPS on the ex-dividend date. That’s because there are other factors at play, such as general stock market moves on the day or news that’s relevant to the company’s own future prospects.
But, all other things being equal, DPS is stripped out of the stock price on the ex-dividend date (or perhaps over a few days, due to market inefficiencies). Over time, over many stock purchases, it will average out this way.
This should make it clear that there’s no advantage to buying stocks just ahead of the ex-dividend date or, indeed, buying them just afterwards when the price is lower (but when the buyer will miss the next dividend payment). Short-term timing of stock purchases, linked to dividend payment dates, won’t help the investor that’s looking for extra income.
What will help the income investor is buying the right dividend-paying stocks in the first place. This comes from a combination of current dividend yield (DPS as a percentage of share price), the ability of the company to keep paying (financial soundness) and to grow the payments over time (future business prospects), and current market valuation of the stock (whether it’s relatively cheap or expensive).
Company dividend policies vary in their details. But essentially, at the root of it all, companies make a decision about how much they plan to pay out at the total company level, in relation to profits. That’s an absolute cash amount in any given year, and most of the time is independent of the stock price in the markets.
Say a company pays out dividends of $200 million in a year, spread across 100 million shares. That means dividend-per-share (DPS) would be $2.
If the stock trades at $100 then that’s equivalent to a dividend yield of 2%. If it trades at $50 then the dividend yield is 4%. All other things being equal – such as the underlying company profitability and future growth prospects – it’s clearly better to buy the same stock when you can get it at the lower price.
In this simple example, buying low boosts the annual return to the investor by 2% a year, from the extra dividend yield. On top of that, stocks are more likely to rise from a lower valuation than from an already-high one. And prices are more likely to fall from stretched valuations than undemanding ones.
Timing dividend stock purchases just ahead of the next dividend payment offers no advantage to investors. What matters for income investors – in fact, for all stock investors – is buying the right stocks at the right price. Consistently applied, time and patience will do the rest.
Stay tuned OfWealthers,