dividends and stock prices
TRANSCRIPT
COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622
Presentation on
Dividends and Stock Prices
By Irwin Friend and Marshall Puckett, University of Pennsylvania
Published in: American Economic Review, September 1964, pp. 656-682.
May 15, 2011
Presentation Outline
Purpose and motivation
Theoretical & Empirical conclusions
Justification of the problem
Research Methodology
Major Findings
Critical appraisal
Purpose & motivation
Objective: To discuss the limitations of the previous findings, describe various approaches to avoiding those limitations, and present new results that seem more in accord with theoretical preconceptions.
Motivation:Controversy and confusion over the relative importance of dividends and retained earnings in determining the price-earnings ratios of common stocks.
Next, a questionable statement that the statistical studies claimed the strong market preference for dividends.
Research Gap
Research Gap: Market valuation of RE is lower on share price (“RE
effect”)
Justification of the problem
Guiding principle : A dollar of retained earnings should be approximately equal in market value of the dollar of dividends foregone.
Basic regression model used in statistical studies
Pt = a + b Dit + c Rit + eit
Where,Pt = Stock priceDit = Dividend per share of i companyRit = Retained earnings of i companyeit = stochastic terms
Comments Loopholes
Omitted variables Risk variable and externally financed growth rate.
Regression weights Extreme values are much more important but omitted
Random variations in income
Short-run reporting of income and dividend payout influence bias
Income measurement errors
Diversity of accounting procedures employed in business earning rise to measurement errors
Least-squares bias Assumes one way causality between dividends and price, rather dual causality requires the use of a complete model
Reasons of statistical studies yielded biased results:
Comments Modifications
Omitted variables The problem of omitted variables managed by expanding the regression equation to include these variables as separate effects (Fi) on price.
Regression weights Introduced firm effects and the multiplicative relationship in regression model which curve the regression weight biases.
Random variations in income
Introduced the lagged price variable in the regression model – the problem of random income movement is managed.
Income measurement errors
Market estimates for earning normalization is used to meet the problem of short-run earnings movements.
Least-squares bias The problem of least-squares bias handled by specifying a complete model including a dividend supply function as well as the customary price relation.
Verification
Finally, the influence of dividend payout on stock price subjected to time series analysis and its validity were checked.
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Population: Cyclical & noncyclical industries in US
Sample: 5 industries
(chemicals, electronics, electric utilities, foods, and steels)
Data collection: Secondary sources
(Accounting data of selected firms was derived under the sample industries)
Study period: 1956 and 1958
Focus of the study: Dividend and retained earnings effects on stock price
Methodology
Major findings…..
Usual linear relationship - customary strong dividend effect and relatively weak retained earnings effect in three of five industries.
In growth industries (chemical, electronics and electric utilities) more weights relatively is given to retained earnings than in non-growth industries (foods and steels) but the evidence is not uniform. (ref. table 1)
Major findings…..
Holding the firms’ effects constant, dividends have a predominant influence on stock prices. (ref. table 2)
The price effects on dividend supply are probably not a serious source of bias, in the customary derivation of dividend and retained earnings effects on stock price. (ref. table 3)
Major findings…..
Short-run adjustment in prices to current level of
income, the findings suggested that retained
earnings receive greater relative weights than
dividends in the majority of the cases. (ref. table
4)
Based on the normalized procedure on retained
earnings, the finding support the customary
results (ref. table 5). When, the firm effects hold
constant, the results again support the same
customary relation. (ref. table 6)
Major findings…..The detailed analysis of chemical industry,
suggested that the retained earnings become
somewhat more important than dividends as a
price determinant. (ref. table 7)
The firms level analysis under chemical industry,
suggested that price-earnings ratio may have
some tendency to move inversely (12 of 20, -ve)
to the payout ratio in contrast to the customary
assertion and, it is significant. The inverse
movement indicated the strong evidence that the
customary results are invalid. (ref. table 8)
In summary…..The study concluded that in unusual growth
stocks, (chemical industry) dividends has weak
effect on stock price than the retained earnings. In
non-growth industries, investor preferred
dividends.
The study also raised the issue of optimal payout
ratio when different profitability of investment
opportunities, risk, sources of financing, etc is
possible or whether an optimal payout ratio exists
which to some extent is independent of profit
prospects.
The in-depth analysis of commonly used regression model has provide us the in-depth knowledge. The study is useful for researchers who want to pursue through the regression models. Similarly, it is very much useful for early practitioners and academicians.
On the other hand, weak points are; major conclusion is derived from small sample (only 17 chemical companies) and overriding of regression bias (omitted 3 chemical firms) which was considered the weakness of previous studies.
Critical appraisal
Thank you.