The stock market is volatile and share prices change constantly. These changes in share prices results in changes in stock returns. The returns can be negative or positive. There are many factors that influence stock prices. One of them is dividend related decisions.
Dividend decision arises when a company generates profits. A suitable dividend policy is adopted by the board of directors, focusing on how much earnings should be paid to shareholders in the form of dividends and how much should be retained in the company to invest in positive NPV projects (Alam & Hossain, 2012).
Dividend policy is referred to ''the practice that management follows in making dividend pay-out decisions or, in other words, the size and pattern of cash distributions over time to shareholders'' (Lease et al., 2000). The issue on dividend policy has been discussed in various empirical researches for decades and its impact on shareholders wealth and company value is still contestable. Two main theories have stemmed from these researches, namely the dividend irrelevance and relevance theories. A brief description of both theories will be provided in this report.
Furthermore we will analyse the dividend policy of Tesco Plc. and perform an event study at the ex-dividend announcement date to determine the impact of the announcement on the company's share price.
2.1 The Dividend Irrelevance Theory
The dividend irrelevance theory is constructed on the belief that a firm's dividend policy does not have any impact on the firm's value and on shareholders' wealth. The theory argues that a firm's value is determined by financing and investment decisions, and therefore dividend policy has no influence on the firm's value.
In 1961, Miller and Modigliani's study of dividend policy concluded that a firm's value and thus share price remains unaffected by the firm's dividend policy. Their theory was developed upon certain assumptions which can be viewed in Appendix A.
M & M argued that investors are more concerned with a firm's ability to generate wealth through investing earnings in positive NPV projects. They added that if investors want cash dividend, they can do so by selling their shareholdings. Their findings were supported by Lease et al. (2000) who suggested that investors have desired cash flow levels. Their study showed that in order to maintain this cash flow level, investors could sell their shareholdings and generate 'homemade' dividends
The logic of the irrelevance theory cannot be disputed based on the underlying assumptions of the theory. However, many scholars believe these assumptions are rather simplistic and do not hold in the real world. Thus an alternative theory was developed, the dividend relevance theory.
2.2 The Dividend Relevance Theory
In 1976, Black described dividend policy as a ''puzzle''. He questioned the validity of M&M's theory as firms continue to pay dividends. If dividend policy was irrelevant, why do firm pay out cash to shareholders when it could have retained the cash (cheapest form of financing) and invest it in rewarding projects?
Some scholars thus believe dividend policy is relevant. Lintner and Gordon (in Al-Malkawi et al., 2010), the pioneers of the dividend relevance theory argue that shareholders prefer dividend payments to capital gains. Investors are risk-averse and therefore dislike the uncertainty of future capital gains. They prefer lowering their uncertainty levels by receiving regular dividend payments. And a reduction in uncertainty also serves to lower discount rate used by investors to value a firm, which results in a higher firm valuation.
We can therefore see that the main argument of the dividend relevance theory is that shareholders prefer early resolution on uncertainty, for which they will agree to pay a higher price. Thus higher dividend payments will prompt increases in the share price.
3. An Analysis of Tesco Plc. Dividend Policy
Tesco is one of the world's largest retailers, with its operations spanning across thirteen different countries. It currently has a market share of 29.7% of the UK market (Kantar World panel, 2013). The company is the only FTSE 100 company which has managed an increase in its shareholder dividends every year since 1984 (Fool, 2013). The dividend policy of the company evolved in 2006 whereby the CEO of the company announced that the company's objective is for future dividends payment to grow in line with the underlying earnings per share, instead of building dividend cover whilst delivering strong dividend growth which was the previous dividend policy adopted by Tesco (Annual Report, 2006).
In this section of the report, we will analyse the dividend pattern of Tesco over a five year period and link the dividend policy of the company to the theory discussed previously.
Analysis of Tesco's dividend payments
Table 1: Analysis of EPS & DPS of Tesco Plc.
Years
2008
2009
2010
2011
2012
Earnings per share (EPS)
26.61
26.96
29.19
34.25
36.64
% Increase/Decrease
-
1.32%
8.27%
17.33%
6.98%
Dividend per share (DPS)
10.9
11.96
13.05
14.46
14.76
% Increase / Decrease
-
9.72%
9.11%
10.80%
2.07%
Dividend pay-out ratio
0.41
0.44
0.45
0.42
0.40
Retention rate
0.59
0.56
0.55
0.58
0.60
Source: Tesco Plc. Annual Report 2012 and own calculations
By looking at table 1 above, we can clearly see that Tesco's dividend policy follows the dividend relevance theory in that it is paying dividends to its shareholders on a regular basis. The DPS has been growing over the years, averaging a growth rate of 7.93% over the five year period. The EPS has grown at an average rate of 8.47% over the same period. This confirms the policy adopted by Tesco in 2006 that is to grow DPS in line with increase in EPS.
Source: Tesco Plc. Annual Report 2012
An analysis of Tesco's dividend pay-out ratio
Tesco has an average pay-out ratio of 0.43. The chart below shows that the company supports a constant pay-out ratio. This may be a positive sign that Tesco can maintain a stable dividend pay-out ratio even in case of major shocks in the market.
Source: Tesco Plc. Annual Report 2012 and own calculations
Dividend payment v/s FCF
One critique of the constant pay-out ratio is how sustainable it is. We can determine this by analysing the company's dividend payments against the free-cash flow [1] .
Source: Tesco Plc. Annual Report 2009 - 2012 and own calculations
Based on the free cash flow (FCF), the dividends look less secure. FCF did not cover dividend payments over the past five years. However, Tesco maintained their strategy to increase DPS over these years, showing clearly that management do not wish to send the wrong signals to investors even if the company is not doing so well. It seems that it would take a major financial collapse for Tesco to review their dividend policy.
4. An Event Study of Tesco Plc.
The purpose of this event study is to determine what happens to the stock price at ex-dividend date. If the efficient market hypothesis is taken into consideration, then the stock price will fall by the same amount as the dividend. Otherwise there exists an opportunity for economic profit.
Our ex-dividend date in this case is 25th April 2012. We will thus assess the impact of the ex-dividend date on the stock price 10 days prior and after that date. The graph below shows the movement in share price during the said event window.
Source: Yahoo Finance
As can be noted, the share price effectively dropped on the ex-dividend date.
For the purpose of our event study, we have collected data of Tesco Plc. and the FTSE All Share Index from DataStream and Tesco's annual reports. Price indices have been collected on a daily basis, from 2nd January to 31st December 2012.
A regression analysis was run in Minitab which resulted in a linear equation being derived, depicting the relationship between expected return and current market return on the Tesco stocks. The equation is follows:
C1 = - 0.00346 + 0.882 C2
Where C1 = Expected Return,
-0.00346: the y-intercept of the line, and
C2: actual market return on the stock.
Using the above equation we were able to derive the expected return (ER), abnormal return (AR), cumulative abnormal returns (CAR) and t-test through our event window. The results are presented below:
Date
ER
AR
CAR
T-Test
11/04/2012: -10
0.0070
0.0049
0.0049
0.2275
12/04/2012: -9
0.0155
0.0060
0.0108
0.2802
13/04/2012: -8
-0.0137
0.0021
0.0129
0.0976
16/04/2012: -7
-0.0066
0.0030
0.0160
0.1422
17/04/2012: -6
0.0169
0.0062
0.0222
0.2890
18/04/2012: -5
-0.0229
0.0009
0.0230
0.0402
19/04/2012: -4
-0.0062
0.0031
0.0261
0.1447
20/04/2012: -3
0.0015
0.0041
0.0302
0.1929
23/04/2012: -2
-0.0104
0.0025
0.0328
0.1182
24/04/2012: -1
0.0135
0.0057
0.0385
0.2680
25/04/2012: 0
-0.0264
0.0004
0.0389
0.0188
26/04/2012: 1
-0.0121
0.0023
0.0412
0.1080
27/04/2012: 2
0.0079
0.0050
0.0462
0.2330
30/04/2012: 3
-0.0051
0.0032
0.0494
0.1515
01/05/2012: 4
0.0017
0.0041
0.0536
0.1940
02/05/2012: 5
-0.0068
0.0030
0.0566
0.1412
03/05/2012: 6
-0.0029
0.0035
0.0601
0.1654
04/05/2012: 7
-0.0007
0.0038
0.0639
0.1792
07/05/2012: 8
-0.0035
0.0035
0.0674
0.1619
08/05/2012: 9
0.0083
0.0050
0.0724
0.2352
09/05/2012: 10
-0.0115
0.0024
0.0748
0.1116
Max AR
0.0062
Mini AR
0.0004
Max CAR
0.0748
Min CAR
0.0049
Max t-test
0.2890
Min t-test
0.0188
The results are presented graphically below:
As illustrated in table 2 above, abnormal returns could returns could be earned during the event window. The maximum abnormal return that could be earned occurred on the sixth day prior to the announcement date, with an abnormal return of 0.62% per share. The minimum abnormal return was 0.04%, which occurred on the announcement date. The cumulative abnormal returns show a maximum occurring on the tenth day after the announcement date while the minimum was on the first day prior to the ex-dividend announcement date.
The data has been simplified in the above chart. We can clearly note that during our event window, abnormal returns could be earned. This results in a positive trend in cumulative abnormal returns as well.
The results of the t-test show an insignificant value at the announcement date. The maximum value derived from the t-test appears on the sixth day prior to the announcement date, with a value of 0.2890. The positive trend in t-test suggests the probability of occurrence in abnormal returns is rather high.
The abnormal returns show a positive reaction by investors to the dividend announcement. The confidence of investors is boosted up by the fact that Tesco managed to grow its dividend payment, while also providing proof that they believe in the ability of Tesco to maintain a growing business in the future.
5. Conclusion
This study has attempted to explain how vital dividend policy is in organisations and its effect on share price and shareholder value. Dividend decisions have a key role to play on the performance of the firm and can positively or negatively impact on the objectives of the firm.
The Efficient Market Hypothesis assumes symmetric information thus investors cannot make abnormal returns on stock price volatility. However, the market is rarely efficient. Information asymmetry in the market results in better-informed market participants to generate abnormal returns (Quresi et al., 2012).
We have investigated the impact of dividend announcement on share price and stock returns of Tesco in this report. Our analysis has prompted us to conclude that the announcement has had a positive effect of stock returns, as positive abnormal returns could be earned ten days prior and after the announcement date.
