Is the Value of Stocks Affected By their Dividends?
The dividends issued by companies do not necessarily affect the intrinsic value of the company but have the potential to affect its stock valuation. The valuation of stock investments is not directly affected by the dividends because they are not included in the calculations of the valuation metrics which are used by companies. However, the dividend activity of a company or the yield from dividends can definitely affect the sentiment of investors and shift the price of the stock which results in changing the valuation of the stock.
How Can Dividends Affect The Valuation of Stocks?
First and foremost it must be clear that the dividend which is announced, does not have a direct impact on the valuation of the stock. Regardless of whether an investor is receiving a dividend on the stocks he or she has or not, the valuation metrics that are used for the calculations are usually the same. The most common among them is the price-to-earnings ratio and the price-to-book ratio among others. However, the potential of dividends affecting stock prices and their valuation does exist in several ways.
For example, if a company increases its dividend beyond the expectations of the market, it can be considered as a positive sign which can boost the valuation of the stocks. Similarly, a reduction in the dividend can also be interpreted as a sign of trouble which could result in the prices of the stock being decreased.
Dividends have the potential to create a price floor for the stocks which may otherwise not be existent. Investors may not consider it worth risking money in a stock which yields just 4%, but may certainly reconsider their decision if they notice any drop in the stock valuation along with an increase in the yield of the stock to 6%. This is perhaps one of the reasons why many stocks that were paying high dividends managed to perform better than their counterparts that were not paying any dividends in 2008 when the financial crisis grabbed a foothold on the market.
Having given a brief explanation it must also be mentioned that dividends in most cases have a psychological impact on investors and can, therefore, shift the prices of the stocks as investors that are enthusiastic begin to purchase or concerned investors begin to sell.
It is also important to mention that share prices can fall by the value of the dividend and lower the price to earnings ratio or other valuation metrics which are based on prices. This is commonly referred to as the ex-dividend date.
The Dividend Discount Model
Another method which is commonly used for evaluating stocks by the dividends they pay, is identified as the Dividend Discount Model. This model simply utilizes the idea that stocks are worth the sum total of all their future dividends.
The dividend discount model has several versions which are being used but the most popular among them is the Gordon Growth Model. This model estimates the dividend of the next year, the cost of equity capital of the company along with its estimated growth rate of future dividends in order to arrive at an intrinsic value of the stock.
The Gordon growth model is not considered as the perfect way to value stocks because it only considers the dividends that are paid without taking into account the financial condition of the company, the growth rate or any other factors which may be important. It just gives investors information about how much they should be paying for a dividend stock in order to achieve the desired return on investment. The model also makes certain assumptions which are not considered as accurate because it takes into account a constant growth rate in the dividends year after year.
Therefore even as the dividend discount model can be considered as useful it should only be used as part of the various calculations when trying to understand whether a stock is valued attractively or not.
Dividends do not affect the valuation of the stocks directly unless flawed methods of calculation are used such as the dividend discount model. However, the dividend activity of a company can definitely be the reason for shifts in the prices of stocks which has the potential to change its price to earnings ratio and price-to-book ratio along with other valuation metrics.
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