When you buy a home using a mortgage, the difference between the market value of your home and the amount you still owe your mortgage company represents your equity, or the amount that belongs to you. Stockholders' equity is much the same. When you own company stock, your actual equity is the value of the company's assets after all company liabilities have been deducted, divided by the number of stock shares owned by all investors.
If you own shares of company stock, you are more than just an investor, you are a company owner. As a company owner, you are entitled to your share of the company's profits along with all other investors. Some companies distribute profits directly to investors in the form of dividend payments. Dividend payments transfer equity from the company directly to you, the shareholder, which consequently reduces equity represented by each share of stock.
Cash Dividends and Retained Earnings
When a company chooses to pay a cash dividend, it pays it using retained earnings. Retained earnings represent the amount of money the company earned doing business over the past quarter after all expenses, such as salaries and the cost of the goods sold, are subtracted. Retained earnings are an asset, so when a company spends its cash to pay stockholder dividends, total stockholders' equity is reduced by the amount of the dividend payments.
Not all dividends are paid in cash. Some companies give you extra shares of stock in lieu of paying a cash dividend on each share of stock you own. When a company pays a stock dividend, it increases the number of stock shares owned by stockholders. This action dilutes the equity amount represented by each share of company stock.
Ex-dividend day is the day a stock begins trading without its dividend. In other words, to receive a dividend, you must own the stock before ex-dividend day. Because dividends reduce equity by the amount of the dividend paid, the stock exchange that your stock trades on reduces the share price of your stock by the amount of the dividend per share before the market opens, reflecting this reduction.
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