There is a positive relationship between past returns and current dividend changes. The relationship is stronger when stock returns convey more private information. This relationship indicates that when corporate managers are making decisions about dividend policy, they rely on new but previously unknown information that is embedded in stock prices.
The authors base their research on the premise that corporate outsiders may hold information unknown to corporate managers. This information could be held by traders of the firm’s shares based on demand for a firm’s products, the firm’s investment opportunities, and the competitive environment in which it operates. The authors argue that the private information held by corporate outsiders is conveyed through abnormal stock returns to the share price of the firm.
Their analysis indicates that lagged abnormal stock returns and the magnitude of current dividend changes are highly positively correlated. This finding is robust to the use of several price informativeness measures and adjustments for managerial private information and stock overvaluation measures.
How Is This Research Useful to Practitioners?
Dividend policy is critical for participants in financial markets. Depending on the type of stock, historical dividends and expected dividends may form the primary basis for valuation for market participants. But for corporate managers, dividend policies are important elements of their firms’ investment policies. Dividend payments can be large sums, can occur frequently, and could lead to significant market reactions. Dividends also influence key financial decisions, such as real investments, capital structure, corporate actions, and the retention of earnings.
An improved understanding of what variables influence dividend policy can enhance explanations of other related corporate finance decisions. Managers can exploit any novel information to optimize their dividend policies. Investors and shareholders can use that enhanced understanding to assess the future prospects of a firm based on its dividend policy changes.
How Did the Authors Conduct This Research?
The authors test the relationship between changes in dividend policy (dependent variable) and stock price changes (independent variable) as well as how the informativeness of stock price changes (independent variable) affect this relationship. They use a sample of quarterly dividend changes from 1962 to 2010 for nonfinancial and nonutility US industrial firms with shares listed on the NYSE and AMEX, which produces a sample of 98,535 observations for 2,510 unique firms. Of this sample, there are 16,240 observations for 1,994 unique firms with nonzero values of dividend change.
The dividend change is defined as the difference between the current and the previous quarterly dividend payment divided by the prior quarterly dividend payment. Dividend announcements are selected following the filters defined by Grullon, Michaely, and Swaminathan (Journal of Business 2002). The average abnormal daily return over the period between the current and the previous quarterly dividend is used as a proxy for the lagged abnormal revision in the value of the firm’s stock. The degree of informativeness of stock prices is defined as the firm-specific stock variation, which may be correlated with the degree of private information being revealed. This measure reflects the variation in the return on a stock that cannot be explained by market and industry returns.
In their regression, the authors control for several variables that have been shown to be significant determinants of changes in quarterly dividends, relying on the set of controls used by Li and Lie (Journal of Financial Economics 2006) that includes dividend yield, market capitalization, debt, cash, market-to-book ratio, operating income, and dividend premium. Dividend premium is the difference in market-to-book ratios for dividend-paying firms relative to non-dividend-paying firms. The empirical evidence of their regression analysis indicates that there is a statistically significant positive relationship between abnormal returns and the likelihood of a dividend increase. They also find that firm-specific stock return variation strengthens this relationship. As abnormal returns increase, dividend cuts become less frequent. Growing firms that have greater investment opportunities are less likely to increase dividends.
Ultimately, the authors seek to understand what information insiders have relative to outsiders of the firm. When the stock price moves strongly in response to an earnings surprise, insiders are deemed to have relatively more information than outsiders, and dividend increases become less likely.
Dividend policy is critical to management and to the investor. The authors, in going against the current and widely accepted notion that useful private information can only reside with corporate insiders, have highlighted another useful facet of evaluating and assessing dividend policy changes. But inherent in their proposition are the challenges in determining how to accurately measure what constitutes private information embedded in public prices. Nevertheless, their rigorous approach clarifies and supports the notion that corporate managers are indeed influenced by what happens in secondary financial markets. But investment analysts who are looking for a ready tool with strong predictive capabilities should be careful in relying solely on the results of the authors’ analysis because of the challenge mentioned.