Much research has been conducted on impact of dividend announcements on the stocks returns. The results are mixed and ranges from no impact of dividend announcements on stock returns to positive and negative impacts when dividends increase or decrease respectively. This concept is also known as efficient market hypothesis which states that markets if are efficient will reflect all the information immediately, hence stock returns reflects dividends announcement as soon as they are announced. One of the earliest studies carried out in this regard are by Petit (1972) who found that market used dividend information in pricing securities. Whereas the phenomena exists from Lintner (1956), who states that managers believe that dividend changes are highly dependent on permanent earning changes and that managers have more information about the future cash flows and future earnings capacity of the company. Most important factor that managers consider on deciding dividends is company's future earnings (Leventis 2011). He also adds that managers wants to keep dividends stable and hence gradually changes to reach their targets. Therefore, the dividend announcement carries a lot of information for investors.
Researchers like Stevens (1989), Ariff and Finn (1986), Kato (1995), Gordon (1959), Lee (1995) and Ogden (1994) has found that stock markets show significant higher than average returns following dividend announcements. Further, Rozeff and Kinney (1976) explains that above normal returns are observed in month of January and companies release more information in January hence above normal returns can be attributed to this increased release of information in the markets. Lonie (1996) investigated dividend announcements of 620 firms in UK from January 1991 to June 1991 by means of event studies and found that investors responded to change in dividend whether dividends are increasing or decreasing. Fuller and Goldstein (2010) found that dividends matter more to shareholders in declining markets. Ball and Kothari (1991) studied dividend announcements and stock prices in US from 1980 to 1988 and found that abnormal returns follows dividend increase announcements. Foster and Vickery (1978) and Gordon (1962) confirm this view and documents evidence of positive abnormal returns after dividend declaration announcements. On contrary Easton and Sinclair (1989) have found statistically significant negative returns followed up by cash dividend announcements. This can be attributed to the income tax effect as cash dividends are taxed and tax on capitals gains can be deferred or is lower so investors put negative value on cash dividend announcements, hence price of stocks fall. Yunnan (2011) verifies it that decrease in taxes in 2005 in China led to increase in dividends by companies.
Acker (1999) investigates effect of dividend announcement on stock volatilities instead of stock returns and finds that stock volatilities around dividend announcement date increases particularly on final dividend announcement date. DeAngelo and DeAngelo (1990, 1992) studied dividend adjustments by troubled or loss making companies in New York Stock Exchange. They proclaim that there is a strong reluctance to omit dividends while companies only cut their dividends in periods of financial distress. Dividend cuts are observed after persistent losses while companies avoid cutting their dividends when losses are temporary or transitory. From this interaction of losses and dividend changes it is implied that some private information about manager's perception about the company is conveyed to outsiders through dividend announcements.
Uddin and Chowdhry (2003) investigated impact of dividend announcements on stock returns on Dhaka Stock exchange in Bangladesh using 137 companies announcing dividends from October 2001 to September 2002. The results for abnormal returns were statistically insignificant concluding that the dividend announcements had no information content in Dhaka Stock exchange.
Theories explaining relationship of stock returns to dividend changes
Many theories have been proposed to explain positive (negative) relationship of stock returns to dividend increase (decrease). Three of these theories are widely accepted: information signaling, free cash flow and clientele effect.
Information Signaling
Since managers have more information about the future financial performance of the company, the announcement of dividends is taken as providing some information to the investors. Lintner (1956) suggests that managers will increase dividends when they are positively confident about the future performance of the company. However, it may also be taken as negative information that company does not have enough positive value adding opportunities to invest hence it is distributing cash to shareholders. It may also be taken as negative if shareholders are taxed higher on dividends compared to capital gains. In other words dividend announcement conveys important and valuable information about permanent changes in the earnings of the company.
John and Williams (1985) formalized this theory as "signaling theory" and suggests that changes in dividend reflect changes in expectations about future earnings of the company. Bhattacharya (1979) supports this by mentioning that dividends give information about the future cash flows of the company in imperfect market conditions. The company increasing dividend is claiming that it will have sufficient cash flows in future to sustain these dividends.
Watts (1973) tried to find out relationship between unexpected dividend changes and future earnings. Future earnings were forecasted using current dividends rather than earnings. Hi did not find any significant relationship between unexpected dividends and future earnings. Penman (19840 and Genodes (1978) also made the same conclusion in their studies. Bernartzi (1997) also studied the same and concluded that dividend policy is related to past earnings rather than future earnings.
Besides studies testing relationship between dividends and earnings it has also been investigated whether the dividend announcement has information content. Watts (1973) in his study, using monthly data rather than daily data, did not find any abnormal returns following dividend announcements. Modgliani and Miller (1961) suggested that in no tax world dividends does not has any effect stock returns as shareholders themselves can create dividends for themselves by selling or buying shares. However, Bernartzi (1997) in his study found evidence that increase in dividends cause positive abnormal returns while decrease in dividends cause negative abnormal returns.
Sometimes it is a problem to study effects of dividend announcements because earning announcements are made in close to dividend announcements. Swary (1980) developed research by Watts (1973) by overcoming its limitations and separating effect of dividend announcements from earnings announcements. He established that dividend does effect stock prices and has its own information content. The studies of Laub (1976), Woolridge (1982), Mullins (1983) and Travlos (2001) also confirmed that dividend announcement does carries information and effects the stock returns.
Free Cash Flow Hypothesis
Another theory explaining relationship between dividend change and abnormal returns is free cash flow hypothesis arising from agency theory (Jensen 1976). Jensen and Meckling (1976) describe agency theory as separation of management from owners and each agent works in their own interest. Agency theory exists because of information asymmetry and conflict of interest among the management (agent) and the shareholders (principal). The free cash flow hypothesis by Jensen (1986) argues that management wants more free cash flow under their discretion to avoid the risk of bankruptcy, therefore are not willing to pay cash as dividends. Management may also have more perks and invest this cash in projects which are not actually value adding or are negative value projects. According to Eisenhardt (1989) problem here is that shareholders cannot verify if management has behaved appropriately in shareholder's interest who are actual owners of the company.
Jensen (1986) states that shareholders use dividends to monitor and discipline the management's action rather than direct intervention to management decisions. Therefore the increase in dividends is considered as positive information and reducing agency costs as management will have less cash available and it becomes less likely to invest in negative value adding projects. Similarly the increase in the dividends implicitly states that the future earnings of the company will be better in future. Thus the dividend announcement has an information content which aligns management's interests with those of shareholders of the company.
Easterbrook (1984) also supports free cash flow hypothesis. According to Easterbrook (1984) and Rozeff (1982) paying out dividends does reduce agency problems. High dividend paying firms often require external funding from the market. Therefore these firms are subject to stricter monitoring and evaluation by the investors in the market. It is often argued that free cash flow hypothesis is similar to dividend signaling theory and both convey information about the company to the market. However, the free cash flow hypothesis claims that information conveyed is related to behavior of the management rather than future expected financial performance of the company. Some studies have used Tobin-Q ratio to measure the overinvestment which distinguishes between dividend signal theory and free cash flow hypothesis. Litzenberger (1989) have used the same approach and documented in his study that free cash flows hypothesis plays better role than dividend signaling theory in explanation of relationship between dividends and its effects on stock returns.
Client Effect Hypothesis
Third explanation for the relationship between the dividend changes and abnormal stock returns is client effect hypothesis. Some investors would like to have earnings paid out to them as cash so that they can use it or invest it on their own while others will want the company to retain the earnings so that they can have a capital gain together. Therefore some companies focus on shareholders who prefer earnings to be paid out and pay regular dividends, whereas some companies focus on shareholders who prefer earnings to be retained in the company and be reinvested. These preferences differ mostly because of tax regulations and different treatment of dividend income and capital gains income.
In many countries dividend income is taxed at higher rate than capital gains. It was the situation in United Kingdom until 1997 and in United States until 1986, but is no more effective. Similarly, in Pakistan capital gains are exempt from tax while dividend income is taxable. When the tax treatment on capital gains and dividend income is same then shareholders are indifferent whether the earnings are paid out as dividends or earnings are retained and reinvested within the company. Black and Scholes (1974) and Miller (1982) argued that there should not be any relation between the dividend changes and abnormal returns even if tax treatment is different on both capital gains and dividend income. Similarly Black (1976) claims that it is a puzzle that dividends have no effect on firm value but still companies pay dividends.
The investors, who are liable to pay higher tax on cash dividends, will prefer earnings of the firm to be retained rather than being paid out. In such a case, the announcement of the dividends will be taken as negative information because these investors will have to pay higher taxes in future, hence their response will be to short such shares and long non-dividend paying shares. Miller and Modgliani (1961) and Black Scholes (1974) formulized this tax preference as tax clientele effect.
However, some investors may still prefer dividend payments rather than capital gains due to their personal preferences or tax exemptions for themselves. Some investors believe in a bird in hand is worth two in a bush which means that they prefer certain dividend over uncertain capital gains in the future. Pension funds and institutional investors need stable income to pay income and pensions to its holders since it is not easy to liquidate shares quickly. Verma (1995) and Short (2002) in their studies found positive relationship between the dividends being paid out and institutional ownership. Therefore the decrease in dividends is seen as a negative event by the institutional investors.
Some research has been conducted to test the effect of the dividend announcement on the value of the firm using dividend model by Brennan (1970). Litzenberber and Ramaswamy (1982) in their research concluded that dividend does have an effect on value of the firm while Black and Scholes (1974) found no evidence of dividends having any effect on value of the firm. Bajaj and Vijh (1990) argued that it is difficult to distinguish between dividend signaling and client effect hypothesis. Bajaj and Vijh (1974) also concluded that significance of effect of dividend changes on stock prices depends on the level of dividends previously being paid by the company. If a firm is paying high dividends and increases its dividends then it will have a more significant effect on stock price compared to if it was paying lower dividends. Dennis (1994) studied clientele effect and free cash flow hypothesis and confirmed that dividend changes does have an effect on stock prices.
Similar studies by Waymire (1994), John Lang (1991), Park (1995) and Cheng (2005) were also conducted to study insider trading. Such studies assume that dividend announcements do have an effect on stock prices. To test for insider trading the event study is carried out around dividend announcement dates. If share prices are found to be responding before the official dividend announcement date then it can be concluded that insider trading does exists and information is reflected in stock prices even before the announcement of the event.
Existing research in Pakistan
A number of studies have been done on effect of dividend announcements on stock returns of the Pakistani companies. For example Nishat and Irfan (2001) in their study rejected the dividend irrelevance theory concept by Modgliani and Miller. They used 160 companies listed in the stock exchange during the period 1981 - 2000 and concluded that dividend announcement does have an effect on the stock returns of Pakistani companies listed in Karachi Stock Exchange. The researchers used dividend yield and dividend payout as a proxy for dividend payout and included these both factors along with earnings volatility, long term debt, growth and size in their regression model which attempted to explain price volatility. The researchers concluded that dividend yield does have negative impact on share price volatility. Similar results were found when joint earnings and dividend announcement effect was studied by Nishat (1992) for the period 1980 - 1986. He established that both dividend announcement and retained earnings have influential effect but dividend announcement effect is stronger than earnings announcement effect.
Kanwer (2002) also studied dividend policy of 317 firms listed in the Karachi stock exchange over 1992 - 1998 time period and used regression model with dividend yield as dependent variable and a dummy variable to proxy for signaling effect based on if earnings increased or decreased in the future. The author supported the signaling theory that future earnings have a positive relationship with the increased dividend yield.
Kaleem and Salahuddin (2006) conducted an event study to test the impact of dividend announcement on share prices in Lahore stock exchange using 24 firms over the period 2002 - 2003. They supported the Modgliani and Miller's dividend irrelevance theory that dividend announcement do not have significant impact on share prices. Mubarik (2008) studied 32 announcements in oil and gas industry over the period 2004 - 2008 and concluded same that dividend announcement does not have any effect on stock returns. However, Zaman (2007) analyzed effect of different events on share prices using multiple regression models but studying only prominent 6 firms listed in three stock exchanges of Pakistan. He concluded that announcement does have significant effect on share returns.
Different authors have reached different conclusions under different set of assumptions. Some accepted dividend irrelevant theory while many are proponent of dividend announcements having an effect on stock prices. The differences are due to different set of studies or small samples being taken in most of the studies.
Table 1: Showing existing research on dividend signaling in Pakistan
Author
Sample
No of Observations
Method of research
Findings / Results
Type
Time Period
Akbar and Baig (2010
79 companies listed in Karachi Stock Exchange
2004-2007
129
Abnormal returns using event study
*The stock returns were mostly negative
during the event window
*The abnormal returns were significantly positive during the event window of dividend announcements.
Mubarik (2008)
5 Companies in Oil and Gas Marketing sector
2004-2008
32
Event Study methodology
*Established insignificant negative values for AAR and significant negative value for Cumulative abnormal returns on the date of dividend announcement
*Also established that dividend and stock price had weak and inverse relationship among themselves
Zaman (2007)
6 companies listed in Karachi Stock Exchange
2000-2005
7
Event Study and Regression
*Stated that dividend announcement and earnings announcement has significant positive effect on share prices
Kaleem (2006)
24 companies listed in Lahore Stock Exchange
2002-2003
200
Event study using abnormal and cumulative abnormal returns
*Results were that dividend announcement did not had any effect on share prices and followed MMs dividend irrelevance theory
Kanwar (2002)
317 companies listed in Karachi Stock Exchange
1992-1998
2219
Regression using dividend yield and dividend changes as dependent variable
*Supported the signaling theory that future earnings are associated with the dividend yields
Nishat (2001)
160 firms listed on Karachi Stock Exchange
1981-2001
3200
Regression Model analysis using dividend yield and dividend payout as dependent variable
*Concluded that dividend policies does effect the share prices in Pakistan
