As pointed out by Gwilym and others(2006), though the dividend payout ratio has been the subject of extensive theoretical modeling by corporate finance researchers, the payout ratio has been neglected in the asset pricing and predictability literature. Arnott and Asness (2003) addressed this oversight, finding a positive relationship between the payout ratio and ten-year future earnings growth over the period 1871 to 2001. In testing that mean reversion in earnings was responsible for this relationship, a negative coefficient on a lagged earnings growth variable was found, though this did not subsume the power of the payout ratio. Ping and Ruland (2006) tested the dividend-earnings relationship at the firm level, given that the results at the market level may potentially be dominated by a few large firms. Their results also supported Arnott and Asness (2003), while holding under numerous specification tests. The coefficient on the payout ratio also remained positive and significant under different tests of the mean reversion in earnings hypothesis. Last, an interactive variable of the payout ratio and market to book ratio was negative and significant, indicating that when growth opportunities are limited, the relationship between the payout ratio and future earnings growth is stronger, supporting the free cash flow. Al-Twaijry (2007) has done a similar company based research for the Kuala Lumpur stock exchange, Malaysia as a semi-developed country. Al-Twaijry research results were statistically insignificant, which meant dividend policy and earnings growth was irrelevant. Therefore it was contrasting with both orthodoxy and empirical findings from other equity markets. Empirical studies made so far covers mainly developed countries. Al-Twaijry made a contribution from a country that has different economic constraints than developed ones. Robert and Asness (2003) examined that companies with higher payout ratios e.g. dividends actually have higher real earnings growth over the following 10-year period. They analyzed data from the S&P 500 index over the years 1946 to 2001. Over every rolling 10-year period the highest dividend payers had the highest earnings growth. Adam and Sun (2004) examined whether the market interprets changes in dividends as an indication about the persistence of past earnings changes and also defined whether a change in dividends alters investors' as assessments about the valuation inferences of past earnings. The result concluded that the changes in dividends cause investors to revise their expectations about the persistence of past earnings changes. Lipson Carlos P, and William (Autumn, 1998), examined that the performance of newly public firms and compares those firms that initiated dividends with those that did not. They compared non-initiating firms declared dividends with respect to initiating firms; the promised dividend would have equaled about 8.5% of earnings, significantly above the 5% level for initiating firms. Harry, DeAngelo, and Skinner, (2009) studied on corporate payout policy grounded in the pioneering contributions of Lintner (1956) and Miller and Modigliani (1961). They conclude that a simple asymmetric information framework that emphasizes the need to distribute FCF and that embeds agency costs (as in Jensen (1986)) and security valuation problems (as in Myers and Majluf (1984)) does a good job of explaining the main features of observed payout policies - i.e., the massive size of corporate payouts, their timing and, to a lesser degree, their (dividend versus stock repurchase) form and also concluded that managerial signaling motives, clientele demands, tax deferral benefits, investors' behavioral heuristics, and investor sentiment have at best minor influences on payout policy, but that behavioral biases at the managerial level (e.g., over-confidence) and the idiosyncratic preferences of controlling stockholders plausibly have a first-order impact.
Importance of Dividends
In 1956 Lintner published his pioneering research about the distribution of corporate incomes and started the discussion of dividends and their value for investors. This paper was covering empirical studies and included interviews with company management of selected companies. Twenty eight companies were selected from a group of 600 well established companies. He chose companies to reflect different factors affecting dividend payments and policy. Lintner stated 'savings... are largely a by-product of dividend action taken in terms of pretty well established practices and policies'. So companies were building their dividend policy first and according to this policy they were distributing dividends and keeping the remaining earnings in the company. While building dividend policy and making dividend payments following list of factors were taken into account:
Gross plant and equipment expenditure; usage of external finance; industry; company size; frequency of changes in rates; average earnings on invested capital; average price-earnings ratios; balance-sheet and fund flow liquidity; stability of earnings; capitalization; use of stock dividends, extras, and splits; the size and importance of stock ownership by management and other control groups. (Lintner, 1956)
Every one of these aspects has formed a focus for discussions, both academically and professionally. That said, the dividend planned to be paid in a particular year was decided by taking the existing rate, company and shareholder interests into consideration. If a change in dividend is needed the new dividend was decided relative to existing rate. Company managers were trying to draw a consistent line of dividend payments over the years. Management believed shareholders prefer incrementally growing dividends and this is also awarded by a premium by the market. Thus management avoided dividend changes that may be reversed soon. They were trying to avoid any adverse reaction from investors resulting by a decrease in dividend in the future
The reason to change dividends has had to be strong to give enough motivation to management. Also management has to believe a change in dividend will be appreciated by shareholders and the financial community. In that sense current net earnings after tax meet these requirements as they were announced and followed widely. Management of companies interviewed were feeling the obligation to distribute increases in earnings with compliance to their dividend policy. If there was a substantial decrease in earnings managers believed a decrease in dividends would be justified too. As a result dividends were decided relative to earnings and a significant change in earnings was reflected to dividends.
'Speed of adjustment' was commonly used to draw a consistent path of dividends along with dividend policy. Management reflected only a portion of the rise in earnings to dividend, and only if it is necessarily big enough. If achieved performance kept in the following periods, the payout rate gets closer to the rate over previous years. If the earnings achieved were the same level they keep their adjustment year by year getting close to the previous payout rate with a speed of adjustment depending on the company. This way of adjustment gave management more comfort in dividend payments and in some cases the ability to sustain dividends when earnings got lower than before. On the other hand as a result of speed of adjustment the amount of earnings retained increased and provided more slack for managers.
Companies were divided into two groups. The first group of companies- forming two thirds of the list had a definite policy about the ratio of dividends and earnings, and the second hadn't. In this first group most of the companies also defined the speed of adjustment of the ratio of dividends to earnings. They were gradually reflecting the increase in earnings to dividends by years till it gets to the previous state. Two companies in the sample were paying fixed rate of earnings as dividends.
Pay-out ratios were defined by taking companies' requirements and shareholders' interests into account. They were changing from a minimum of 20 percent to 80 percent and 50 percent was the common payout ratio in general. Except two companies reflecting every change in earnings to dividends in full, other companies were practicing speed of adjustment. Speed of adjustment was changing from company to company and unlike pay-out ratio there was no common figure in this one. Payout ratios and speed of adjustment were shaped by several factors depending on company experience, objectives, and operations. These can be listed in detail as:
the growth prospects of the industry and, more importantly, the growth and earnings prospects of the particular company; the average cyclical movement of investment opportunities, working capital requirements, and internal fund flows, judged by past experience; the relative importance attached by management to longer term capital gains as compared with current dividend income for its stockholders, and management's views of its stockholders' preference between reasonably stable or fluctuating dividend rates, and its judgment of the size and importance of any premium the market might put on stability or stable growth in the dividend rate as such; the normal pay-outs and speeds of adjustment of competitive companies or those whose securities were close substitutes investment wise; the financial strength of the company, its access to the capital market on favourable terms, and company policies with respect to the use of outside debt and new equity issues; and management's confidence in the soundness of earnings figures as reported by its accounting department, and its confidence in its budgets and projections of future sales, profits, and so on. (Lintner, 1956)
Companies' managements were keen on dividend payments in a way they could cut working capital to meet such requirements. After dividends distributed, if investment opportunities couldn't met with the internal funds available management reassessed remaining opportunities before going for an external financing. Unless their return is sufficient to raise more capital, by issuing stock or using debt, management postpones the investment plan. If this scenario repeats in following years, management retained more of the earnings and omitted the dividends even it is against the policy of the company.
As a result of managements' self protection and conservatism in dividends create a gap between net earnings and dividends, therefore retained earnings, have increased. Dependence on internal finance had also contributed to the result.
The second group of companies, which didn't have well defined dividend policies, in general possessed similar characteristics with the other party. They had similar payout ratios and speed of adjustment systematic that had resulted similar.
In an effort to build a predictive model Lintner also measured the correlation between dividends paid with net current earnings and with dividends paid last year. Correlations were 0.145 with net current earnings and 0.788 with last terms dividends paid. The model also suggested a fixed positive figure that showed companies' tendency to pay dividends. Results are in line with surveys and study reflected conservatism about dividends paid.
Mohammed and Joshua (2006) examined that the determinants of dividend payout ratios of listed companies in Ghana. The data used which were derived from the financial statements of firms listed on the Ghana Stock Exchange during a six-year period. Ordinary Least Squares model is used to estimate the regression equation. Institutional holding is used as a proxy for agency cost. Growth in sales and market-to-book value are also used as proxies for investment opportunities. Their results show positive relationships between dividend payout ratios and profitability, cash flow, and tax and negative associations between dividend payout and risk, institutional holding, growth and market-to-book value. Miller and Franco (1961), they studied on effect of a firm's dividend policy on the current price of its shares is a matter of considerable importance, not only to the corporate officials, who must set the policy, but to investors planning portfolios and to economists seeking to understand and appraise the functioning of the capital markets.
Joshua and Bokpin (2010) investigated the effects of investment opportunities and corporate finance on dividend payout policy. They tested this issue a sample of 34 emerging market countries covering a 17-year period, 1990-2006 and found a negative relationship between investment opportunity set and dividend payout policy and an insignificant effects of the various measures of corporate finance namely, financial leverage, external financing, and debt maturity on dividend payout policy. In this paper profitability and stock market capitalization are also identified as important in influencing dividend payout policy. William and Arnott (2003) studied that investors would believe that earnings could grow faster than the macro-economy and concluded their evidence that earnings must grow slower than GDP because the growth of existing enterprises contributes only part of GDP growth; the role of entrepreneurial capitalism, the creation of new enterprises, is a key driver of GDP growth, and it does not contribute to the growth in earnings and dividends of existing enterprises. Veikko (1967) studied the relationship between the growth of earnings and the dividend payout ratio of a corporation. His result shows that the stockholders' advantage to adhere to the policy of a high payout ratio even in the case where the tax differential is in favor of capital gains. Lintner (1956) examines the distribution of corporate incomes. To test results used Twenty eight companies from a group of 600 well established companies. Lintner studied on dividend policy and making dividend payments following factors were Gross plant and equipment expenditure; usage of external finance; industry; company size; frequency of changes in rates; average earnings on invested capital; average price-earnings ratios; balance-sheet and fund flow liquidity; stability of earnings; capitalization; use of stock dividends, extras, and splits; the size and importance of stock ownership by management and other control groups.
Miller and Modigliani (1961) examined the effect of dividend policy to a share's current price. They concluded that the dividend policy should not affect the company prospects. Result show that dividend policy wouldn't have any effect on return for shareholders too. Factors that take into account transaction costs, asymmetric information, and tax - depending on investor's situation. Fama (1974) examine to find the degree of relation of the two for companies. He studied 298 firms for a 23 years period covering 1946 - 1968 using Linter's model, Miller and Modigliani's theorem. There is no strong correlation between dividend model and investment models. Peter (2004) examine model of earnings and earnings growth to obtain estimates of the expected rate of return on equity capital. These estimates are compared with estimates of the expected rate of return implied by commonly used heuristics-viz., the PEG ratio and the PE ratio. Proponents of the PEG argue that this ratio takes account of differences in short-run earnings growth, providing a ranking that is superior to the ranking based on PE ratios. Method used by researchers interested in determining the effects of various factors (such as disclosure quality, cross-listing, etc.) on the cost of equity capital. He concluded that stocks for which the downward bias is higher can be identified a priori. Gongmeng, M.F &N.G (2002), examined the information content annual earnings and dividend announcements made. They concluded that unexpected earnings, proxied earnings changes are positively related to abnormal return. They also explained that if the sign of unexpected stock dividend increased or decreased is the same as the sign of unexpected earnings, then the earnings will be stronger. If the earning sign is negative then the earnings will be weaker and there will be little impact of cash dividend on earnings.
Flint, Tan, Gary (2010), examines the use of the payout ratio as a predictor of a firm's future earnings growth; according to the result it rejects the hypothesis that the firms which retain a large portion of their earnings have strong future earnings growth. They provided further evidence that the dividend payout ratio is positively linked to future earnings growth and found that no evidence to support the cash flow signaling and free cash flow hypotheses as an explanation for this relationship.
Nissim and Ziv, A (2001), investigated that the relationship between dividend changes and future earnings, they found that the dividend changes provide information about the level of profitability in subsequent years, the result shows that the dividend changes are positively related with future earnings. Benartzi,S, S.Grullon, G.Michaely, R., Thaler, R. (2005), examined that the dividend changes are positively related with future earnings in sense of profitability, they also showed that the dividend changes are negatively co-related with future earnings changes in sense of return on assets while controlling the non-linear pattern behavior of earnings. They also find the models that are better off for the investors don't use for the dividend changes.
Richard G. Sloan (1996) examined that the stock prices which reflects the information about future earnings that controlled in increases and cash flow mechanism of current earnings. The degree to which current earnings show into the future earnings which is depending on the relative magnitudes of cash flow and current earnings. However investors grip on earnings, failing to reflect full information about the degree to which cash flow components of current earnings impacts on the future earnings.
Dividends in Theory
Miller and Modigliani (1961) acknowledge previous empirical studies made by Lintner and Gordon but also found them inadequate in explaining results. Therefore they focused on framing the subject with theoretical explanations. Starting point of Miller and Modigliani was the effect of dividend policy to a share's current price. They showed algebraically, under such assumptions, the dividend policy should not affect the company prospects.
Perfect capital markets - No transaction is big enough to affect market price, 'all traders have equal and costless access to information', there are no transaction costs, and no difference in taxing any income such as between dividends and capital gains. Rational behaviour - Investors are indifferent between sources of wealth and chooses the one with the most return. Perfect certainty - there is complete assurance in any investment's return whether it is bonds or shares. Miller and Modigliani showed under these assumptions whether all earnings of the company is distributed as a cash dividend or retained as a capital for new investment opportunities it has the same contribution to investors' wealth.
Under these assumptions, every security in the market would have the same return as investors would easily shift to another one with better return. Again with same assumptions dividend policy wouldn't have any effect on share price. The company would be indifferent between distributing earnings as dividends and issuing shares to raise capital or retain earnings.
As a result of same reasons dividend policy wouldn't have any effect on return for shareholders too. That is if a company's investment policy is known, with the help of rational and perfect economic environment; there wouldn't be any 'financial illusions'. Investors would come to same conclusion with assessing 'real' facts.
Authors proved their claims about valuation taking different valuation methods and founding the same algebraic result in each with the help of basic assumptions agreed. These valuation methods were: the discounted cash flow approach, the current earnings plus future investment opportunities approach, the stream of dividends approach, the stream of earnings approach.
Miller and Modigliani emphasized differences between the dividend policy and investment policy of the company: A company is not necessarily bound to its earnings for its investments. They argue with Gordon's findings as he oversaw the effect of investments made and he related pricing of the shares only with dividends and earnings.
Miller and Modigliani have gone further in proving irrelevance of dividend policy to valuation in idealised circumstances. They argued, even investors have had their own expected returns value of any company would be irrelevant to the dividend policy. Investors expected return would be a distribution covering and valuation of a company would be a distribution too but still be irrelevant to dividend policy. The authors noted a perfect rational investing which will avoid any sort of speculation by using 'imputed rationality' and 'symmetric market rationality'. With imputed rationality authors meant while an investor is a rational investor that chooses more wealth to less in any form, also accepts the market does the same and act accordingly. Symmetric market rationality names every investor in the market as a rational investor and they imputes rationality to the market it's self. In that way all valuations would be rational and avoids any 'bubbles' created in a speculative way.
Under uncertainty of future streams of profits and dividends (holding investment policy is not bound to dividend policy) they prove valuation of a company is not relevant to dividend policy. In a world of uncertainty debt financing would be an alternative for the company and investors. If it is more convenient to invest in debts of a company an investor may do so, instead of investing company's shares. An investor buying shares of the company and an investor giving debt to company would be indifferent. If the investment policy is known, the return would be known and valuation wouldn't differ because of risk, and the return would be the same for interest return with a return expected from buying shares in a company.
They noted 'the informational content of dividends' in their uncertainties too. They gave credit to this reasoning but pointed to the underlying facts of what this indication shows investors an expectation of increase in return. Therefore they view this reaction not to dividend change but expected investment or change on return. They didn't support the idea of dividends being an indicator as they may be manipulative or a change in dividend policy only.
Authors also relieved the perfect capital markets to a degree that tax issues wouldn't affect investors already as they could choose companies that could deliver their returns in their favour. Some investors might desire dividends and others might capital gains and with the increasing amount of institutional investors without any tax differential importance of the issues were getting smaller.
Finally with relief of some assumptions Miller and Modigliani showed dividend irrelevance theorem was not distant from the current situation of market. When we turn Miller and Modigliani's findings upside down we can see why researchers think dividends and dividend policy is still important: Transaction costs, asymmetric information, and tax - depending on investor's situation
