Question

5. ABC, Inc. has just announced today that it would pay $1/share dividends to each shareholder of record on June 5, 2019 (Wed). Its current share price is $30 and its shareholders’ average tax rate is 30%. Assume that there are no other news or developments that will affect the stock prices between now and the dates: (A) What will likely be the price of its stock on June 4, 2019 (Tue)? (B) What will likely be the price on June 3 (Mon)? (C) Instead of paying $1 in cash, the company announced today that it would use the aggregate equivalent of $1/share dividends to buy back outstand shares, would its share price increase or decline upon the announcement? Explain.

Answer 1

Declaration of dividends shall have effect on the stock price in a variety of ways. While the historical dividend payment pattern plays an important role, the declaration and payment of dividends for that particular period as well shall have predictable effect on market prices.

The investors shall have two way approaches. Some investors look at equity only for the returns, while some investors look for the value addition of their investment and not any frequent returns. As said, there shall be some investors for whom dividends serve as a popular source of investment income. For the company, dividend distribution is a way to reward the shareholders to thank them for their support and confidence in the company. Dividends also serve as an announcement of the reflection of the company’s performance.

When companies maintain the history of consistent dividend payments, they become more attractive to investors. With this effect, there shall be a surge in demand which increases the the stock price naturally, thus reinforcing the confidence that the stock is strong. Also, if the declared dividend is higher than any other year, the public sentiment tends to rise.

On the other side, when a company declares a lower divided, than the average trend of historical dividends, it may be interpreted as a indicator that the company is undergoing tough times.

Considering this trend, its natural that the investors shall purchase the stock before ex-dividend date and will be willing to pay a premium on the price. This demand and willing to pay premium shall result in the price of the stock to increase in the days leading up to the ex-dividend date. In general, the increase is about equal to the amount of the dividend, but the actual price change is based on market activity (demand supply).

On the ex-dividend date, investors may push down the stock price by the amount of the dividend to consider the fact that new investors are not eligible to receive dividends and shall therefore unwilling to pay a premium.

Also, there are many people who invest in certain stocks only at certain times to collect dividend payments. These investors purchase shares just before the ex-dividend date and then sell them again right after the date of record;

in this case of ABC Inc, Record Date is June 5th and Ex-Dividend Date is June 4th;

Buyback:

Generally, some companies with good reserves in its Balance Sheet go for Buyback of the shares. The impact of the buyback is to reduce the number of outstanding shares in the market and this increases the ownership stake of the stakeholders.

Buybacks are one of the efficient ways for companies to return profits/ value to the shareholders. They reduce the total number of shares outstanding and this potentially boost stock prices as demand outstrips supply.

During Buyback, the companies cannot force shareholders to sell their shares in a buyback, but they usually offer a premium price to make it attractive. This premium price attracts some set of investors and this creates a sudden surge in the price of the shares in the open market to acquire more number of shares further to offer to the company for buyback. Once the shares are bought back, the outstanding shares are retired by the company and the overall ownership restricts to lower number of shares than the situation before buyback.