Before the ex-dividend date, the shares include the right for the next dividend payment (they are "cum-dividend"). On and after the ex-dividend date, the shares no longer include this right (they are "ex-dividend"). This is why the share price often (but not always) goes down on ex-dividend date.
Before and after ex-dividend date
Anyone who is holding shares at the end of the day just before the ex-dividend date will receive a dividend. For example, if you hold 200 shares and the dividend is $1 per share, you will receive $200. The cash will actually be paid on some later date, but the end of day before the ex-dividend date decides who gets the money and how much.
Even if you sell your shares on the ex-dividend date (or on any day after), your right to this dividend payment will be unaffected – you will still get the cash. Conversely, if you haven't owned shares before and only buy them on or after the ex-dividend date, you won't get any dividends.
Imagine a company that, for simplicity, is doing nothing at the moment (not generating any profits or losses). It has $1,000 in its bank account and no other assets or liabilities. Apparently, the company is worth $1,000 at the moment.
It has issued 10 shares, so each share is worth $100. Shareholder A holds 7 shares (worth $700) and Shareholder B holds 3 shares (worth $300).
Dividend announcement date
On 1 March the company's management announces that the company will pay a dividend of $20 per share, the ex-dividend date will be 1 May and the dividend will be paid on 1 June.
There are three important dates to distinguish with dividends:
- Dividend announcement date = when the dividend is announced to the public (1 March in our example)
- Ex-dividend date = number of shares held just before this date decides who gets the dividends and how much (1 May)
- Dividend payment date = the date when the shareholders actually receive the cash (1 June)
Stock price before ex-dividend date
Let's say on 30 April (when the shares still include the dividend rights) Shareholder A sells one of his shares to Shareholder C. The share price will most likely be $100.
After the stock trading ends on 30 April and before it begins on 1 May (the ex-dividend date), the company records who the shareholders are and how many shares each is holding at that moment:
- Shareholder A holds 6 shares and will receive a dividend payment of $120 ($20 per share times 6).
- Shareholder B holds 3 shares and will receive $60.
- Shareholder C holds 1 share and will receive $20.
On 1 May, the ex-dividend date, when the stock market opens, the shares no longer include the dividend rights. Who gets the dividends has already been decided the night before.
If Shareholder A sells 2 shares to Shareholder D on 1 May, that sale won't affect the dividend payments, because the stock is "ex-dividend" now. Shareholder A, now holding only 4 shares, will still recieve $120 dividend, because he was holding 6 shares when the dividend was allocated. Shareholder D, although now holding 2 shares, will recieve no dividends, because his purchase came too late for that.
Stock price after ex-dividend date
At what price will Shareholder A sell the shares to Shareholder D on ex-dividend date? What is the fair value of one share at this moment?
The company still has $1,000 in its bank account, because the dividends will only be paid on 1 June. However, now it has a $200 liability to pay the dividends. Therefore its fair value is $800, or $80 per share. Assuming the stock market price exactly corresponds to the company value, the shares should be trading at $80 on the ex-dividend date.
The stock price decreased by $20, the dividend amount.
Stock prices in reality
In reality, stock prices rarely go down exactly by the dividend amount on ex-dividend date. Prices of shares on the stock market don't equal their fair value, for the simple reason that it is impossible to know the exact fair value (it was only possible for the very simple company in our above example) and different market participants have different opinions on what the fair value is.
The stock may drop more than the dividend amount, it may drop less, or it may even go up. There are many factors which affect where the stock price will go on the ex-dividend date, as on any other day.
Trading volume around ex-dividend date
That said, trading activity can often be higher on ex-dividend date. For tax, administrative or other reasons, some investors prefer to receive dividends, while others prefer to collect their returns in the form of capital (stock price) gains. Therefore, some may buy a stock just before the ex-dividend date and sell it immediately after, or vice versa.
Tax legislation features, such as different tax rates for dividends and capital gains or various tax credits, can open up tax avoidance opportunities, which can be exploited by trading around the ex-dividend date. Such tax-motivated trades, known as dividend stripping and dividend washing, are restricted in some countries.
Ex-dividend date meaning for investors
Most investors don't need to worry about stock prices going down on ex-dividend date, as these losses are, on average, offset by the dividends received. Apart from the above mentioned tax or administrative reasons, a stock going ex-dividend is not a factor that significantly affects returns.
One mistake beginner stock traders sometimes make is considering a stock price drop on ex-dividend date a trading opportunity. An inexperienced trader (or one who doesn't do his homework) may see a stock going down and take it as an opportunity to buy, unaware of the ex-dividend date. Whenever you see a big drop in a stock price without any news possibly explaining it, ex-dividend date is one of the first things to check.