Aurora Borealis
1 October 2015 CFA Institute Journal Review

Communicating Private Information to the Equity Market before a Dividend Cut: An Empirical Analysis (Digest Summary)

  1. Marc L. Ross, CFA

Using empirical analysis, the authors research firms’ decisions to release information in anticipation of a possible dividend reduction and the implications of the dividend cut.

What’s Inside?

The authors use the scenario of a company’s proposed dividend cut as a template to gauge possible optimal means of communication with the public in advance of a corporate action. Meaningful differences result when such a disclosure is prepared versus nonprepared.

How Is This Research Useful to Practitioners?

The authors endeavor to understand how firms choose to communicate negative private information to the markets preceding a dividend cut as well as the effects of that cut on various performance indicators. They examine a cross section of firms that either prepare or do not prepare the market for such a corporate action. A firm is considered a prepared dividend cutter if insiders release information at least 30 days before the formal dividend cut announcement date. Otherwise, a firm is a nonprepared dividend cutter.

The authors use two models to evaluate a company’s decision about whether to prepare the market before a dividend cut. The assumptions of these models are in part shared and complementary.

In the signaling through market preparation model, the authors consider how markets react to firms of high, medium, and low intrinsic value that prepare the market for a potential cut in the dividend. Firms with high intrinsic value do not prepare the market for a dividend cut, whereas firms of medium value do with high probability. In contrast, firms with low intrinsic value inform the market with much lower probability and suffer an adverse market reaction.

The stock return volatility model posits no difference in long-term intrinsic value between prepared and nonprepared dividend-cutting firms. It also indicates that market preparation is a way to stagger the dissemination of unfavorable news to mitigate the volatility of the firm’s stock price that may occur with a dividend reduction.

The authors suggest that firms with positive longer-term prospects experiencing nearer-term financial difficulty would do well to prepare the markets for a potential dividend reduction, yet meting out such information over time may not be the best way to decrease market volatility. They base their conclusions on a comparison of prepared and nonprepared dividend cutters on the metrics of long-term operating performance, dividend payments, changes in institutional equity holdings, and stock returns.

Students of market volatility and corporate finance would find the authors’ contributions innovative and welcome. Additionally, the research serves as the basis for further investigation into the effects of corporate actions in general on a firm’s stock price.

How Did the Authors Conduct This Research?

A dataset from numerous sources of firms that reduced or omitted their cash dividends over a 24-year period (1982–2006) is the basis for the authors’ inquiry. The firms are publicly traded and pay a cash dividend. Firms that may experience another corporate event at the same time are excluded from the dataset to avoid contaminating the findings. The winnowing produces a final sample of 401 announcements of dividend cuts.

Standard procedures in the literature guide the authors’ construction of variables for each firm’s growth, profitability, size, payout ratio, leverage, return volatility, and institutional ownership. These variables help to gauge the effects of prepared versus nonprepared dividend cuts. The authors develop testable hypotheses based on the aforementioned signaling and stock volatility theories. They further subject their findings to robustness tests to control for any survivorship bias.

The authors’ empirical analysis shows that firms with short-term poor profitability but more promising long-range prospects are more inclined to prepare the markets for a dividend cut. Furthermore, prepared dividend cutters tend to experience less return volatility in the wake of a cut than nonprepared firms. Finally, the prepared firms experience better long-term operating performance, dividend payout, institutional ownership, and stock performance than their nonprepared counterparts.

Abstractor’s Viewpoint

Preparedness matters in the world of corporate actions, at least as much as it applies to the communication to the marketplace of a possible dividend cut. As the first empirical analysis of its kind, the authors’ investigation considers a firm’s decision about whether to release such private information to equity markets in anticipation of a possible dividend reduction and the consequences of such an action. Their methodology, with some modification, could apply to other forms of corporate action that entail a decision to communicate negative information to the marketplace as the subject of future research.

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