Ask a Fool: How do dividends affect stock valuation?

Dividends don’t directly affect the valuation of stock investments, as they aren’t included in the calculation of most valuation metrics. However, a company’s dividend activity or its dividend yield can certainly affect investor sentiment and move the price of the stock, thereby changing its valuation.

How do dividends affect stock valuation?

First of all, a dividend doesn’t have a direct impact on a stock’s valuation. Common valuation metrics such as the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and most others are calculated in the same way regardless of whether a stock pays a dividend.

Having said that, dividends can affect stock prices and valuations in several ways.

For example, if a company raises its dividend higher than the market expects, it could be taken as a positive sign and boost the stock’s price. Similarly, a dividend cut can be interpreted as a sign of trouble and could result in a depressed valuation.

Dividends can also help to create a “price floor” in stocks that otherwise may not exist. For example, if a certain stock yields 4%, it may seem not worth the risk to many investors. If the price drops and the stock’s yield jumps to 6%, they may reconsider. This is a reason many high-dividend stocks performed better than their non-dividend counterparts during the financial crisis in 2008.

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In other words, dividends often have a psychological effect on investors and therefore can move a stock’s price as enthusiastic investors buy or worried investors sell.

It’s also important to mention that on a stock’s ex-dividend date, the share price will fall by the amount of the dividend, lowering the stock’s valuation accordingly in terms of P/E or similar price-based valuation metrics. For example, if a stock trades for $20 per share and earned $1 per share over the past 12 months, the stock’s P/E is 20. However, if the stock pays a $0.50 dividend, the share price will theoretically drop to $19.50, making the stock’s P/E 19.5.

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The dividend discount model

There is one method of valuing stocks based on the dividends they pay, known as the dividend discount model. Simply put, this model uses the idea that a stock is worth the sum of all of its future dividends.

Several versions of the dividend discount model exist, but the Gordon Growth Model is the most common. It uses next year’s estimated dividend, the company’s cost of equity capital, and its estimated future dividend growth rate to calculate the intrinsic value of the stock.

Naturally, this is a far from perfect way to value a stock. For starters, it only takes dividends into account — not the company’s financial condition, growth rate, or any other factors. It just tells you how much you should be willing to pay for a dividend stock to achieve a certain required rate of return. It also makes certain assumptions that aren’t likely to be accurate, like a constant dividend growth rate year after year.

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Thus, while the dividend discount model can be useful, it should be used as just one piece of the puzzle when deciding if a stock is attractively valued.

The bottom line

Dividends don’t affect the valuation of stocks directly, with the exception of significantly flawed valuation methods like the dividend discount model. However, a company’s dividend activity can certainly be the cause of movements in a stock’s price, which can cause its P/E, P/B, and other valuation metrics to change.

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