Cash dividends and stock repurchases are two major forms of payout to
stockholders. They influence stock prices and returns and thus decisions for
investing and trading in stocks. The authors analyze the behavior of U.S.
corporations that paid dividends and repurchased shares in the 1972–2000
period. They address the relative merits of dividends and repurchases from the
corporation's point of view, the substitutability between the two forms of
payout, and the differences in their tax treatment from the investor's
perspective. Their findings are of interest to corporate financial officers,
equity analysts, and portfolio managers.
A significant shift has occurred in the behavior of U.S. corporations in making cash
distributions (quarterly dividends versus stock repurchases) to stockholders. The
authors investigate the reasons for this shift in U.S. corporations' payout policies.
They also analyze the data to determine whether corporations use stock repurchases as a
substitute for cash dividends. More importantly, they explore the question: Why did
corporations neglect to repurchase more intensely before the mid-1980s, when the tax
benefits of capital gains were much higher? In addition, the authors investigate the
effect of share repurchases on investors' reactions to dividend decrease announcements
and the effect of taxes on the market reaction to share repurchase announcements.
The data for the study come from the industrial Compustat files. The sample includes
those corporations whose required data were available for the entire study period
(1972–2000). The final sample consists of 15,843 corporations and an overall total
of 134,646 corporation-year observations. For assessing the shifts in payout policies
and estimating transition probabilities, the authors place the sample corporations into
four categories: (1) Div = 0 and Repo = 0, (2) Div > 0 and Repo = 0, (3) Div = 0 and
Repo > 0, and (4) Div > 0 and Repo > 0. For testing whether share repurchases
and cash dividends are substitutes for each other, the authors examine the relationship
between dividend forecast errors and share repurchase yields. They use such statistical
techniques as tests of mean differences between groups and regression analysis to make
inferences from the data. The major findings are as follows.
For the study period, the dividend payout ratios declined, but the overall payout ratios
(dividends and share repurchases combined) stayed relatively constant because the
corporations that repurchased shares increased from 31 percent in 1972 to 80 percent in
2000. During that period, the dollars spent on share repurchases grew at a compounded
annual growth rate of 19 percent compared with 8.5 percent for the dollars paid out as
cash dividends. Furthermore, the number of corporations that initiated a buyback program
increased from 26.6 percent in 1972 to 84.2 percent in 2000. The authors also find that
corporations substituted share repurchases for dividends. This conclusion was inferred
from the finding that the market reaction in response to dividend decrease announcements
was significantly less negative for repurchasing corporations than for nonrepurchasing
corporations.
Despite a decline in the tax benefits associated with capital gains, share repurchases
have increased substantially during the post-1986 Tax Reform Act (TRA) period. During
the 1972–79 period, as much as 23 percent of corporations that initiated cash
payouts did so with cash dividends; this proportion fell to only 2.4 percent during the
1992–2000 period. Contrary to this result, the number of corporations that
initiated cash payouts with share repurchases rose from 14.33 percent during the 1970s
to 29.62 percent during the 1990s. The authors' explanation is that the corporations
were “simply wrong” in shunning repurchases before the mid-1980s or they did
not want to risk violating the antimanipulative provisions of the Securities Exchange
Act of 1934. Notably, repurchasing activity increased after the adoption of Rule 10b-18
in 1982, which provided a safe harbor to corporations repurchasing their own stock.
Statistical analysis using pre- versus post-period comparisons and time-series
regressions confirm this observation. In regard to the differential taxes between
dividends and capital gains, the authors also find that market reaction to share
repurchases was more positive during the pre-TRA period than during the post-TRA period.
What corporation characteristics cause differentiation in payout policies? The data
reveal that dividend-paying corporations (Div > 0) are much larger, are more
profitable, and have less-volatile returns on assets than corporations that do not pay
dividends (Div = 0). Repurchasing corporations are younger and experience a higher
earnings volatility than dividend-paying corporations. Interestingly, corporations that
pay dividends and repurchase shares have earnings volatility equal to 3.4 percent and
account for 87.9 percent of the aggregate amount of share repurchases. In contrast,
corporations that only repurchase shares have earnings volatility equal to 7.5 percent
and represent only 12.1 percent of the repurchase activity. This finding supports the
view that corporations use share repurchases to pay out extraordinary transitory
earnings and use dividends to pay out permanent earnings.
The authors' findings have important implications for stock valuation and investment
management. Because dividends and share repurchases are shown to be substitutes for each
other and because U.S. corporations are relying more on share repurchases now than in
the past, stock valuation tools (e.g., dividend discount models) should appropriately
consider the total payout rather than dividend payout alone.