Why does the price of a stock really drop on ex-dividend date?

Question

I know that the price of a stock on the ex dividend is supposed to drop by the amount of the dividend. What i don't understand fully is why it happens. I have seen many answers/articles/books etc that parrot multiple ideas that don't make sense with reality. For example many answers even on this site say that the price drops because cash is going out the company, therefore it is worth less, etc.

Many of these reasons don't make sense because the reality is that the price of a stock on ex-dividend DOES NOT drop by the dividend when it opens at 930AM EST. it drops by the dividend amount at open during the PRE-MARKET.

In other words, it is NOT people buying and selling the stock that makes it drop by the dividend amount. There seems to be something else that causes this change.

I have seen some articles that point to the fact that the stock exchanges themselves arbitrarily SET the price of a stock to be lower, but not many places talk about this more in detail.

It's not individuals buying and selling based on some perceived sense the company is worth less, because that would happen when the stock starts trading at normal times, since that is when you need to hold the stock to even get the dividend. if people really sell their shares on ex-dividend date before market opens, they won't get the dividend. So that doesn't make sense.

So what REALLY causes the price stock to drop? Is it the stock exchanges/market makers that set the price to start lower for the day to prevent people from making free money from the dividends? this question is specific to the US stock exchanges though i would be interested in knowing if this happens in others around the world as well

Answer 1

A dividend does not create any value, it just transfers it. The value of the company (and hence its ownership shares) must drop to reflect the cash that's paid by the dividend.

Suppose there was a company whose only asset was $100 cash and it had 1 share of stock. That share would be worth $100. If that company paid the shareholder a $5 dividend, what are the assets of the company now? Id would have $95 in cash, so its share would be worth $95. The "owner" of the company goes from having one share worth $100 to a share worth $95 and $5 in cash. No wealth is created, only transferred.

Exactly when that happens is not relevant to why it happens. At some time around the ex-div day, the shareholders transition from owning a $100 share to a $95 share and the right to $5 cash. IF you bought a share instantly before that time, you'd pay $100 and be entitled to the dividend. If you bought it immediately after, you'd pay $95 and not be entitled to the dividend. Either way you're have $95 worth of stock after the dividend clears.

The exchanges and brokers will adjust limit and stop orders (which determine the bid/ask) so that buyers don't inadvertently pay $100 after the dividend is paid. It's possible that a buyer could put in a new limit order immediately after the ex-div date for the pre-div price, but I do not know how common that is or if there any safeguards or warnings to prevent it.

Answer 2

Company is REALLY worth less on ex-dividend day than was the day before. It is just that simple. If something pays out $100 from its assets, it is $100 worth less.

It does not matter if the stock is traded on an exchange during the premarket period. When you buy premarket on ex-dividend day, you still do not have rights to get the dividend. So naturally, you would like to pay less than the day before.