Most people believe it is impossibly hard to understand how interest rates and dividends affect the value of the share price of a stock, but if you can understand opportunity cost then you can understand these concepts. Understanding these concepts will not only make you a better investor, but they will also allow you to make sense of seemingly irrational stock market fluctuations.
When things are going good for a company or they consistently make a nice profit, then they will sometimes increase the dividend payout. Let us take a historical example using General Electric (GE). A historical dividend increase from $0.60 per share annually to $0.68 per share annually took place on December 9, 2011. On December 8, 2011 GE stock closed at $16.31 which made the dividend yield about 3.68%. When GE announced that they would be raising the dividend payout to $0.68, the stock rose by 3.3 percent to $16.84 which made the dividend yield about 4.04%.
The lesson here to learn is that many investors who invest in blue chip dividend-yielding stocks price them like bonds or fixed income with a higher risk. Investors that use this approach are generally wealthy or do not need their investment funds in the short term. We have said the dividend yield was around 3.68% before the dividend payout increase. If the shares had not gone up 3.3 percent, then the dividend yield would have been around 4.17%, but instead investors bought up shares and drove the yield down to 4.04%. This yield is still higher than the 3.68% yield, but why would investors drive the share price up and the dividend yield down? They are treating it like a bond is the answer. It makes sense that you would pay more for a higher yield. For example, if you owned an apartment complex that churned out $50,000 in rent a year, you would pay more to own it than an apartment complex that produced $20,000 in rent a year. All things equal, a dividend increase will generally raise the share price of a stock for this reason. Investors will pay more for a higher yield.
Investors will usually buy up shares until the new dividend yield is near the previous dividend yield when dividends increase. Using this knowledge, what if GE were to fully restore its dividend payout to what it was in 2008 before the major stock market crash? In 2008, GE had a dividend payout of $1.24. If GE were to raise its dividend to $1.24 overnight, then what would investors pay to own the stock? Right now (at the time this was originally written) GE trades at $22.03 which gives it a dividend yield of 3.09%. To get the dividend yield down to 3.09%, the share price would have to increase to $40.13 which is an increase in the share price of 182%. If an investor believes that GE will eventually restore its dividend to $1.24 per share, then he or she would want to be buying up as many shares as possible right now in anticipation of the upward swing in share price that would result (Alas, we know this didn’t take place as of this posting!). However, before buying up as many shares as possible, he may want to create a forecast for interest rates.
Why would he or she care about what interest rates will be in the future? It just so turns out that interest rates matter to dividend yields A LOT. Remember that we mentioned a lot of long term investors value blue chip dividend-yielding stocks like bonds with high risk. Right now these investors are happy with a 3.09% dividend yield in GE because they cannot make a lot of money with bonds. Bonds have such a low yield because inflation is so low right now. If inflation picks up very quickly and rises to around 5% then bond yields will also raise a lot. Now if bond yields are higher, then these investors will demand a higher dividend yield in GE stock to own it. Investors would probably demand a dividend yield of around 8% because they treat GE like a high risk bond (high risk bonds have higher yields than low risk bonds). This means that even if GE were to raise its dividend payout fully to $1.24 like in 2008, the share price may only be $15.50 because investors are demanding a higher dividend yield due to inflation and increased interest rates.
This means that GE could have fully restored its dividend payout but the share price could actually decrease to $15.50 rather than rise to $40.13 if interest rates increase. This is simply because investors demand a higher yield to leave the relative safety of bonds. The important lesson to learn here is that a decrease in the stock price can sometimes not be because the underlying business is flawed but because the opportunity cost of owning the business has increased due to increased yields elsewhere such as in government bonds.
This is why investing is so difficult. To create a sound investment strategy you have to predict what will happen to interest rates, dividend payout, and market demand for yields. One investor may expect the dividend payout to be fully restored but refuse to buy GE shares because he or she believes inflation will increase the demand for yield and drive the stock price down to $15. Another investor may believe the dividend payout will be fully restored and interest rates will remain low with benign inflation which would increase the share price to around $40. A third investor may believe GE’s fundamental business will perform poorly, and decide to avoid it regardless of interest rates, inflation, and dividend.
You really do have to think for yourself as no one will be able to give you the answer as to what will happen in the future. This quick explanation is actually all most beginning investors need to know to understand certain swings in stock prices in reaction to inflation or dividend changes. As you can see, it all comes down to opportunity cost. If you can earn a higher yield somewhere else then why would you ever keep your money in a lower yielding asset? Asset prices with lower yields will come down until the yield is competitive enough for investors to buy up shares!
Note: As we have seen, the Federal Reserve has kept interest rates near the zero bound for a long time. Because there is no yield in bonds (or any asset for that matter), investors have piled into equities as an alternative to even find a yield. Because it would take a massive amount of stock purchases to make the average dividend yield near zero, the stock market theoretically has no upper bound while interest rates are near zero. This means investors will likely continue to inflate stock market prices simply because there is no alternative (TINA theory). Beware though… I suspect that if inflation ever spills over to the real economy or interest rates are ever raised by the Federal Reserve… there will be a sharp, painful re-pricing of all equity markets. Until that day… enjoy the ride!