do dividends predict future firm performance?...theoretical foundations one of the first scholars...
TRANSCRIPT
Stian Abrahamsen Tobias W. Balchen
BI Norwegian School of Management Master Thesis
Do Dividends Predict Future Firm Performance?
Exam code and name: GRA 1903 Master Thesis
Hand in date: 01.09.2010
Program: Master of Science in Business and Economics
Major in Finance
The thesis is part of the MSc programme at BI Norwegian School of Management. The school takes no responsibility for the methods used, result found and conclusions drawn.
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Content
ACKNOWLEDGEMENTS ......................................................................................................... II
ABSTRACT ................................................................................................................................ III
INTRODUCTION ........................................................................................................................1 LITERATURE REVIEW................................................................................................................................ 2 Theoretical Foundations................................................................................................................... 3 Empirical Findings............................................................................................................................... 5 Private vs. Public Firms and Dividend Policy ........................................................................... 7 The Norwegian 2006 Dividend Tax Reform ............................................................................. 8
DATA.............................................................................................................................................9 FILTERING.................................................................................................................................................10 DATA DESCRIPTION AND DESCRIPTIVE STATISTICS.........................................................................11
PRELIMINARY FINDINGS .................................................................................................... 17 PAYOUT RATIOS .......................................................................................................................................17 Preliminary conclusions ..................................................................................................................23
METHODOLOGY ..................................................................................................................... 23 HYPOTHESES ............................................................................................................................................24 CONTROL VARIABLES..............................................................................................................................25
EMPIRICAL FINDINGS: ......................................................................................................... 26
CONCLUSION ........................................................................................................................... 31
LIMITATIONS AND FURTHER RESEARCH...................................................................... 32
REFERENCES: .......................................................................................................................... 33
APPENDIX; PRELIMINARY THESIS: ................................................................................. 36
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Acknowledgements
We would like to express our gratitude towards our supervisor Bogdan Stacescu
for excellent supervision, time and inspiration. We would also thank him for being
flexible and helpful during our stay abroad. We would also like to thank the
Centre for Corporate Governance Research for providing us with the data.
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Abstract
In this paper the effect of changes in dividend policy on future firm performance
for non-listed firms are analyzed. Our study is on small and medium sized unlisted
Norwegian firms. First we establish that these firms are highly flexible in setting
their dividend policy, changing it frequently. Further with univariate analysis we
find some support for the Lintner view, were the management only increase the
dividends when earnings are expected to increase permanently. With multivariate
regression analysis we find a strong relationship between a dividend increase and
an increase in the earnings. However, we are unable to find support when future
earnings are investigated; hence the information content of the dividends
hypothesis is rejected.
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Introduction
Stock markets and investor behaviour suggest that dividends have information
content. When dividends are increased a firm’s stock price tends to increase and
vice versa when dividends are cut (e.g. Grullon et al., 2002). In the literature
regarding dividend payout policy this notion of information content is supported.
Many theories suggest that changes in dividends contain some information
regarding the future profitability and earnings of the firm. More precisely many of
these theories predict that dividends are positively correlated with future
profitability and earnings. One such theory is the signalling hypothesis, which is
based on information asymmetry between managers and investors (e.g
Bhattacharya,1979, and Miller and Rock, 1985). With this asymmetry they claim
that dividends are used as explicit signals about future earnings, which the
management sends out intentionally and at some cost to the investors. According
to Bhattacharya (1979) the signalling cost stems from the fact that dividends are
taxed at a higher rate than capital gains (Bhattacharya 1979). Miller and Rock
(1985), however, view the loss of funds to use in investments as the major
signalling cost.
A prediction of the dividend signalling hypothesis is that dividend changes are
positively correlated with future changes in profitability and earnings, hence the
share price movements discussed above are observed. According to Grullon et al.
(2005) this is one of the most important issues in corporate finance; hence it is of
interest to investigate these theories more thoroughly. This is a task that has been
pursued by many scholars; however so far no definite agreement has been
reached.
The signalling hypothesis have been widely researched, however, as stated above,
there are contradictory findings in the literature. Some studies give support for the
signalling hypothesis (Nissim and Ziv 2001, Bhattacharya 1979), while others
finds no or limited support for it (Grullon et al. 2005, Benartzi et al. 1997). Our
research will give indications on whether the theory is supported for Norwegian
non-listed firms.
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Most of the research on this subject has employed data from listed firms. In this
paper, however, the relationship between dividends and future firm performance
for private firms in Norway will be investigated. With this approach we have most
of the framework available in prior work, but the research will be done on data
that has not been researched extensively. This analysis can yield interesting results
and possibly add new insights to the debate about the relationship between
dividends and future earnings.
A standard assumption is that information asymmetries are a larger issue for small
and unlisted firms, which can imply support for the signalling hypothesis.
Nevertheless it can be tempting to believe that there is no strong correlation
between the change in dividends and the change in future earnings for private
firms. A first argument is the Modigliani and Miller irrelevance theorem (kilde?),
which states that firm value is independent of finance structure. From this it
follows that investors are indifferent to whether dividends are paid out or if
earnings are reinvested profitably. Another argument is that the management in
private firms in many cases is the actual shareholders, and in the cases with
outside shareholders they are often very “close” to the management. The fact that
to use dividends as a signalling-strategy is costly could then induce the
management of private firms to choose another strategy. In the cases were the
insiders and outsiders are the same individuals there is indeed no need to send a
signal. Our research will therefore give us an interesting, and useful, indication on
how private firms use dividends, and which of the theories we find support for.
The rest of the paper is organized as follows. First we introduce the relevant
theories on dividends, and how dividends can be used as a signal about the future
performance of a given firm. In addition to this the most important empirical
findings to date are presented. Section two outlines the set-up of our data and
methodology, and defines the different measures and variable used in this paper.
In section three we run multivariate regressions while controlling for several firm
specific variables, before concluding in the last section.
Literature review
The dividend signalling theory is highly disputed; there are several scholars who
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have theoretically documented that the dividend signalling theory should hold.
However in the empirical literature there are contradicting findings, some scholars
have found evidence supporting the hypothesis, e.g. Nissim and Ziv (2001)
whereas others have not, e.g. Benartzi, Michaely and Thaler (1997)
Theoretical Foundations
One of the first scholars who contributed to the theoretical foundation of the
signalling hypothesis was Sudipto Bhattacharay. In the paper “Imperfect
Information, Dividend Policy, and “The Bird in the Hand” Fallacy” (1979) he
develops a theoretical model in which dividends function as a costly signal for
expected future cash flows. Hence changes in dividends should convey
information about future cash flows. It follows that dividend decreases are bad
news (lower future cash flow) and dividend increases are good news (higher
future cash flow). The author develops these results by assuming that outside
investors have imperfect information about firm’s profitability and that cash
dividends are taxed at a higher rate than capital gains. The fact that dividends are
taxed at a higher rate is the major cost that leads dividends to function as a costly
signal.
In the model of Bhattacharya outside investors cannot distinguish the profitability
of productive assets held by firms, and existing shareholders care about the market
value assigned by outsiders. Investors ignore other sources of information than
dividends “on the ground, taken by themselves, that they are fundamentally
unreliable screening mechanisms because of the moral hazard involved in
communicating profitability” (Bhattacharay, 1979, 260). From this it follows that
the communication of even ex post cash flows from existing assets is costly,
because only dividends can convey this information and dividends are taxed
higher than capital gains.
In conclusion Bhattacharya develops a model where dividends can function as
explicit signals about future earnings, sent intentionally and at some cost by
management to the firm and its stockholders.
Merton Miller and Kevin Rock (1985) analyzed dividend policy of firms when
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information is asymmetric. When there exists asymmetric information the state of
information with respect to earnings, investment and net dividends at the time of
the dividend announcement is different for firm insiders and outsiders. For an
outsider an important and easily available component of public information is the
dividends, hence dividends are critical for the market valuation of the firm. An
insider, however, also has information on unannounced earnings; this will
naturally lead to a difference in the perceived value of the firm. The model, which
is developed in this paper, proposes therefore dividends as a signal to outsiders on
how insiders view the economic future of the firm. For the firm, this is a costly
way of communicating. This is in accordance with Bhattacharya (1979), however
Miller and Rock view the major signalling cost as the loss of funds to use in
investments, and not the higher tax rate dividends faces. Due to this cost,
signalling with dividends only makes sense for the good-news firms, and not the
bad-news firms. It is only for the good-news firm that the cost may be worth
bearing in order to avoid giving the market a false impression that earnings were
not high enough to justify a dividend.
Another signalling equilibrium model is proposed by John Kose and Joseph
Williams in the article “Dividends, Dilution and Taxes: A Signalling Equilibrium”
(1985). The intuition of their model is that a firm must either retire fewer
outstanding shares or issue new shares in order to raise funds for investments. As
firms, current stockholders have to sell existing shares to raise cash on personal
account. If either of this happens, then current stockholders will suffer some
dilution in their fractional ownership of the firm. When inside information is
favourable, the reduction of this dilution is valuable for the current stockholders.
As a consequence insiders, acting in the interest of their current stockholders, may
distribute a taxable dividend if outsiders recognize this relationship, bid up the
price of the stock, and thereby reduce the dilution of current stockholders. Insiders
will therefore control dividends optimally and outsiders pay the correct price for
the firms’ stock. In equilibrium insiders with truly more valuable future cash flow
will distribute larger dividends and receive higher prices for their stock, whenever
the demand for cash by both the firm and its current stockholders exceeds its
internal supply of cash. Thus in Kose and Williams (1985) model there should be,
at least in theory, a positive relationship between an increase in dividends and
future cash inflow.
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Empirical Findings
There are many scholars who have tried to empirically document a relation
between dividend changes and future firm performance, for instance Benartzi,
Michaely and Thaler in their article “Do Changes in Dividends Signal the Future
or the Past” (1997). In this article the authors utilize a large number of firms and
events and they control for many factors that can create spurious relationship
between dividends and subsequent earnings changes. Their results, both by
utilizing categorical analyses and regression analyses, indicate a very strong
correlation between dividend changes and both lagged and contemporaneous
earnings. However, they are unable to find much evidence of a positive
relationship between dividend changes and future earnings changes.
Because of their findings the authors ask if dividend changes can be a signal of
something else than the expected value of future earnings. One possibility is that
dividend increases are a signal of a permanent shift in earnings (as Linter (1956)
suggests). They do indeed find some support for Lintner’s view. Nevertheless,
their results indicate,
that if firms are sending a signal, (a) it is not a signal about future earnings
growth and (b) the market doesn’t “get it”. Why firms would burn money to send
a signal that is not received is, indeed, a mystery (Benartzi et.al. 1997, 1009).
Unlike Benartzi et al. (1997) Nissim and Ziv (2001) present the “information
content of dividend hypothesis”, which states that dividend changes trigger stock
returns because they convey new information about the firms’ profitability. Doron
Nissim and Amir Ziv (2001) investigate this hypothesis and they find a positive
relationship between dividend changes and future earnings changes, future
earnings and future abnormal earnings. Further they find that dividend increases
are positively related to earnings in each of the four subsequent years, but that a
dividend decrease is not related to future earnings.
As they explain in their paper, the lack of correlation between dividend decreases
and future earnings does not necessarily imply that dividend decreases are not
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informative about future earnings. Actually, when current year earnings are
omitted, the coefficient on dividend decreases becomes positive and significant.
This, they claim, can be explained by accounting practices. Losses should be
recognized in earnings when anticipated whereas profits should be recognized
only when earned. As a result, current year earnings cannot contain the future
implications of the good news that caused management to increase dividends. On
the other hand, future implications of the bad news that triggered the dividend
decrease should be reflected in current earnings.
In response to the article by Nissim and Ziv (2001) Gustavo Grullon, Roni
Michaely, Shlomo Benartzi and Richard Thaler presented the article “Dividend
Changes Do Not Signal Changes in Future Profitability” (2005), where the
signalling hypothesis is rejected. In this paper the authors claim that Nissim and
Ziv’s assumption of linear mean reversion in earnings is inappropriate. From
econometrics it is known that assuming linearity when the true functional from is
nonlinear has the same consequences as omitted variable bias. Hence the Nissim
and Ziv results may be biased.
The authors therefore employ a model that assumes that the rate of mean reversion
and the coefficient of autocorrelation are highly nonlinear. With this approach the
relation between dividend changes and future earnings disappears. Overall no
evidence is found supporting the idea that dividend increases signal better
prospects for future firm profitability. Further it is also shown that out of sample
forecasts are generally better without using dividend changes as an independent
variable.
Given the evidence presented in this article and others it is sensible to conclude
that changes in dividends are not useful in predicting future changes in earnings.
However the authors do not rule out that dividend increases signal something, but
that something is not an abnormal increase in future earnings or future
profitability.
The literature proceeds in order to try to establish exactly what dividends are a
sign of. In the article “Are Dividend Changes a sign of Firm Maturity” Grullon,
Michaely and Swaminathan (2002) try to answer this question. From this article
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and others there are indications that dividends contain information from market
reactions. Further, by definition fundamental news about a firm has to be either
about its cash flows or its discount rate. The authors claim that since it is not news
about cash flows it must be about the discount rate. They document, by using data
on US stocks, that firms which increase (decrease) dividends experience a
significant decline (increase) in their systematic risk, i.e. a reduction in the
discount rate. On the basis of their findings the develop a new hypothesis, the
maturity hypothesis, which states that dividends contain information about firms
transitions in life cycles to a more mature phase. As firms become more mature
they tend to increase their payouts due to less positive NPV opportunities. Hence
we should expect dividend increases to be associated with subsequent declining
profitability, risk and return on investments that lead to lower capital expenditures
(capex). This hypotheses is related to the free cash flow hypotheses developed by
Jensen (1986), however the free cash flow hypothesis does not contain any
explicit prediction concerning changes in risk, hence it cannot be the complete
story.
To formally test the maturity hypothesis the authors investigates different aspects
of firm performance employing various techniques. Amongst other they analyze
changes in Return on Assets (ROA) and dividend payout ratios. Dividend payout
ratios are interesting because if cash flow signalling models are correct the payout
ratio of a dividend-increasing firm should increase temporarily, and then decline
gradually over time as earnings start to catch up with the increased dividends.
Finally the development in capex and excess cash are investigated. The free cash
flow hypothesis suggests that dividend-increasing firms ought to decrease (at least
keep it constant) their capex. In addition one) would expect to see their cash
balances decline. Their findings support the notion of the maturity hypothesis and
fills in the pieces providing more content to the free cash flow hypothesis.
Private vs. Public Firms and Dividend Policy
The research in this paper deals with private firms, unlike most of the previously
done research on the area. Michaely and Roberts (2007) compare the different
dividend policies between public and private firms, and try to explain why private
firms may have a different dividend policy than public firms. In this paper, the
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authors divide their data sample of UK-firms in three distinct groups; wholly
owned firms, private dispersed firms and public firms.
As stated by Michaely and Roberts (2007), an important difference between a
private- and a public-firm is the ownership structure. Some private firms exhibit
little, if any, separation between control and ownership. If there should exist
outside shareholders, then they are often close family members, or informed and
active monitors, such as corporation with close ties to the firm. This can affect the
dividend policy of the firm. Some private firms may for instance increase
dividend payments not as a signal to shareholders, but maybe because of tax
reasons or instead of wages, although the paper by Michaely and Roberts (2007)
do not find evidence of this.
The authors present three hypotheses in their paper. The most interesting
hypothesis for our work is as follows:
Hypothesis 3: Following dividend increases, operating performance should
improve for Private Dispersed firms and Public firms, but there should be little or
no relation between dividend increases and operating performance for Wholly
Owned firms (Michaely and Roberts 2007, 25).
The hypothesis suggests that the firms that increase their dividends are those who
are undervalued by the market. When they test this hypothesis they come up with
two conclusions. Under symmetric information, firms will not try to signal future
change in earnings with an increase in dividends. This is intuitive since outsiders
have the same information as insiders. But, when information is asymmetric, they
also find no evidence for firms trying to signal higher future earnings with an
increase in dividends. Hence, they do not find evidence of a positive relationship
between high future earnings and increase in dividends, as Nissim and Ziv (2001)
did.
The Norwegian 2006 Dividend Tax Reform
A final aspect that may prove important for our research is the announced
Norwegian tax reform in 2006, i.e. the shareholder income tax. This reform
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increased top marginal tax rates on individual dividend income and capital gain
from zero to 28 percent. Prior to the reform there was a large difference in
marginal tax rates on labour and capital income for medium and high-income
classes. This provided incentives for business owners to re-classify labour income
as capital income, in order to minimize the tax bill.
Since the tax rate currently is positive, the timing of capital gains or dividend
distributions are important. Further since capital gains can be deferred these are
slightly preferred by investors over dividends. This is also discussed by
Alstadsæter and Fjærli (2009) were they show that both the new and old tax
regimes are neutral, and thus the tax reform should have no other effect than on
the timing of dividends. Neutrality implies that the tax is “neutral with respect to
timing of dividends and capital structure of the firm…, and investment decisions
and risk taking”.
Alstadsætar and Fjærli (2009) document a strong timing effect on dividend
payments as a consequence of the tax reform, aggregate proposed dividends
increased by 82 percent the last year before the reform (2005) and dropped by 41
percent in the year thereafter. These tax motivated dividend payments may have
additional costs by reducing the cash holding of firms, thus reduce their
investment capabilities for the future. Finally, they find that the increased
dividend payments increase the firm’s debt to equity ratios. As the findings in
their paper indicate, the tax reform distorted the number of dividend payments
prior to the reform. This may have weakened the relationship between dividends
and earnings, for some time surrounding the tax reform. I.e. firm’s may want to
extract as much as possibly through dividends prior to the tax reform regardless of
earnings.
Data
The data have been provided by the Center for Corporate Governance Research
(CCGR). The CCGR have a special focus on non-listed firms and family firms in
particular, and are thus able to deliver high-quality data on variables that
otherwise would be difficult to obtain. From their extensive database we have
obtained data on 20 variables for non-listed firms. These data are un-consolidated
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account data and also data concerning ownership control. The sample period
ranges from ’94 until ’08, and is on long-panel form. This dataset will allow us to
investigate relationships between dividends and different factors of firm
performance such as return on assets and equity, and changes in earnings. Our
entire sample contains 2 304 743 firm-years, but different filters are applied, to be
explained in the next section, and the final sample consists of 423 392 firm-years.
Filtering
In order to reduce the possibility of including erroneous observations and inactive
shell firms in the sample, a number of different criteria for an observation to be
included are employed. A shell firm is a corporation without active business or
significant assets; in addition “shells tend to be conduits or holding companies
and are generally included in the description of special purpose entities” (OECD
Benchmark Definition of Foreign Direct Investments 2008, 101). For this reason
shell firms are sought excluded from the analysis.
Firms with negative dividends, cash, assets, investments, revenue, bonds and debt
observations were deleted in order to remove possible erroneous observations.
Further the most important criteria in order to exclude shell firms are that all
observations for which a firm has zero employees and observations for which a
firm has zero in revenue are taken out of the sample (please refer to table 1).
For the revenue variable there are no observations for the period ’94 to ’96 and
only a very few for ’97 and ‘98, which implies that with this filter the first four
years of our dataset is lost. However this is also necessary for another reason,
namely that revenue will be used as a scaling factor for certain variables in
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analysis to come. With this as zero or missing the scaling will not work according
to our intentions. We also rule out firms from the sample that over the entire
period do not pay dividends at all.
Further since the dataset is on un-consolidated basis we remove all firms that are
not independent according to the dummy variable “independent”. We face a
challenge in doing this because prior to 2000 there are no observations regarding
firms’ independence. In order to circumvent this problem independence is
extrapolated from 2000 until 1999. This is done on the basis that ownership
structure is quite stable over time; thus extrapolating independence gives more
information, and outweighs the negative effects added by the extra uncertainty
that follows from the extrapolation. After this process is completed we remove all
dependent firms from the sample. After the filtering process our final sample size
consists of 423 392 firm-years covering the time period 1999 to 2008.
Data Description and Descriptive Statistics
Before the first descriptive statistics are reported the variables employed in this
section of the paper will be defined. The dividend variable in our sample is
dividends payable in t+1, i.e. dividends for 2000 are dividend payable for year
2001. Further the dividend change variable is defined as the dividend in year t
minus the dividend in the previous year, scaled on the dividend in the previous
year.
As a measure of profitability we use the Return on Assets (ROA). This is defined
as operating result scaled by total assets:
The change in ROA for firm i is given by:
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Another performance measure we will employ in our analysis is Return on Equity
(ROE), calculated as result scaled by the book value of equity.
In addition we have two alternative measures of the change in result, one where
last years earnings scale the change in result, and one where the change is scaled
on the book value of equity last year.
Finally the payout ratio of a firm is defined as the ratio of dividends to operating
result, and size is defined as the logarithm of revenue:
The dataset included several extreme values, for example the maximum dividend
change was about 1356 percent. In order to reduce the effect of such observations
on the results, these variables have been winsorized at the 1 percent and 99
percent level of the empirical distribution. Some variables, however, are bounded
on one side, e.g. dividend increases at 0, and these are therefore winsorized on the
non-bounded side only. The winsorization procedure follows that which others
have done in this field of research (e.g. Grullon et. al. 2005, Nissim and Ziv
2001).
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With the dataset complete we report the first descriptive statistics. In table 2 an
overview of the types of dividend events by year is presented. The dividend
events are separated in five groups; initiations, i.e. the first year a company pays
out a dividend after a zero dividend year, dividend increases, no change events,
dividend decreases and finally omissions in which dividends are cut to zero.
In table 2 we notice some first signs of difference between private and public
firms. A pattern that can be found in the literature for public firms is that dividend
decreases are much less common than dividend increases. In the article by Grullon
et. al. (2005) the ratio of dividend increasing firms to decreasing is about 24, i.e.
for each firm that reduces dividends there are 24 which increases. The same ratio
for the sample used by Nissim and Ziv (2001) is slightly lower at 16,2, however,
this is still much higher than the ratio in our sample as can be inferred from table
2, which is as low as 1,4. Finally we also notice that initiations and omissions are
almost as common as dividend increases and decreases. This is also quite different
from the data on listed firms, where dividend initiations are much less frequent
than increases in dividends. These findings indicate that the private firms in our
sample are quite flexible and change their dividend policy frequently.
From the table we also observe that the numbers of increases and decreases in
dividends vary somewhat from year to year, while the number of no-change
events is rather stable, although it increases (permanently) in 2006 to above 20
000 observations. In 2005 we observe that most firms (68%) decrease their
dividends, while in 2004 most firms increased their dividends (38%). These
effects are most likely due to the tax reform implemented by the Norwegian
government January 1, 2006, which introduced a positive tax (28 %) on
dividends. The reader must remember that the 2005 dividends are proposed
dividends for 2006. In the years leading up to the reform firms would pay out as
much as possible and then when the tax is introduced dividends are reduced or
even cut to zero in order to minimize the tax bill over time. This also explains the
very high number of omissions in 2005 (23 814) compared to the other years.
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The hypothesis of the tax reform being the main reason for the change in
dividends is strengthened when we analyze the mean operating result scaled by
equity. We find that this variable seems to be relative stable; hence a change in
firms’ results is not likely to be the reason for the change in dividend policy.
When analyzing the absolute value of total dividends paid we can also observe a
drop after the implementation of the tax reform (see figure 1). As explained by
Annette Alstadsæter and Erik Fjærli in their paper “Neutral Taxation of
Shareholder Income” (2009) this can be explained by two factors:
“One is the pure timing effect, as the corporations accelerate their dividend
payments prior to the reform. This is only a transitory effect. The other reason is
that closely held corporations either find substitutes for dividend payments such
as hiding consumption expenditures into the operating expenses of their firm or
that they believe that tax rates will drop again in the future. In the meanwile, the
corporation is used more or less as a savings box. This is a more permanent
effect”. (2009, 26)
.
Figure 1 illustrates the amount of total dividends paid out yearly from 1998 to
2008. As we can see the total dividends paid out increased the first years, and
peaked in 2004. The only decrease during this period came around 2000, which
may be explained by the burst of the dot-com bubble in the end of 2000 and a
temporary tax reform in 2001. After the peak in 2004 dividend payments we can
see a vast drop in dividends, followed by an increase in 2006 before we again
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experience a major decline. The reduction of dividends in 2005 can be explained
by the tax reform as discussed above. Overall the firms in the sample seem to be
affected rather strongly by tax consideration when they pay dividends. The reader
needs to keep this in mind when interpreting the results to come in later sections.
Table 3 contains descriptive statistics on dividend change, ROE and ROA for the
five different dividend event groups.
In table 3 we notice further signs of differences between private and public firms.
For public firms a pattern often emerges in which dividend increases are less in
magnitude than dividend decreases (e.g. Grullon et. al. 2005, Nissim and Ziv
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2001), however the opposite holds in our sample as is clear from the table. The
dividend-increasing group on average increases their dividend with 172 percent
whereas those firms who cut on average do so with 43 percent. However the
reader should keep in mind that that a dividend decrease is bounded at 100
percent.
The total number of firm-years is 423 392, whereof 155 872 are no-change events.
The mean ROE ranges from 13,22 percent for the dividend increases group to
1,51 percent for the no change group, we notice a similar pattern for the ROA
which ranges from 12,73 percent for the increasing group to 1,55 percent for the
no change group. An interesting first finding is that the two groups with positive
dividend events (initiations and increases) seem to have better performance
measured by either ROE or ROA, than the firms with negative dividend events
(omissions or decreases). This finding is consistent with previous literature on
public firms. However the worst performing group is the no-change groups, with a
ROE (ROA) of 1,51 percent (1,55 %), we also note the large size of the no change
group. In order to see whether this group differ in size and ownership structure,
these variables are also reported. As we notice from the table, the no-change
group does not deviate significantly from the others, even though its size on
average is smaller.
Preliminary Findings
Payout ratios
In table 4, panel a, the mean payout ratio per year for the firms that do not change
their dividend (no-change group) is presented. Due to the size of this group and
also its poor performance, measured by ROE and ROA document in table 3, it is
of interest to analyse the group further, especially the mean payout ratio. Until
2005 the mean was around 10 percent, but the last three years the mean payout
ratio has dropped, and been barely 1 percent. In light of the tax reform a possible
reason for this is that owners may decrease the payout ratio because of higher
taxation. Their reason is that they need the money to pay wealth tax, and the table
gives us some indication of this story being true.
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In the same panel we also present the mean dividend paid out for the no change
group. We can see some of the same patterns here; in 2005 the mean dividend was
significantly reduced, at least economically. Further in 2007 and 2008 the total
dividends paid out from this group of firms are only around 20 percent of what
was paid out the year before. The reason for the drop in the payout ratio in 2005
till 2008 is a combination of a decrease in the dividends paid out and the fact that
firms experienced an increase in operational results in this period.
In panel b the mean payout ratio and the mean dividends paid out for the firms
that increases their dividends are presented. We note that on average the firms
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tend to pay out as much in dividends as they have in operating result. Additionally
the mean dividends paid is high, and is almost in all years around 1 000 000
Norwegian kroner. The story of the dividend decreasing firms is presented in
panel c. Also for these firms the payout ratio is relatively high. The mean
dividends paid out are beneath the dividends paid out from the dividend increase
firms, but still relatively high.
Table 5 below illustrate how the changes in earnings behave for firms that
increase and decrease their dividends, and in addition how the earnings behave for
firms that does not change their dividends. In panel a we analyze at the percentage
change in earnings, while we in panel b analyse at the change in earnings scaled
on the book value of equity.
In panel a we note that when dividends are decreased the mean change in earnings
is negative with 14 percent. The change in earnings is also negative (-38%) when
a firm does not change their dividends, and positive (93%) when a firm increases
their dividends. For the “no-change” firms the same pattern emerges in the
subsequent years; i.e. changes in earnings are still negative. For the firms that
decrease their dividends, we observe that the sign changes; hence when firms
decrease their dividends firms tend to do better in terms of changes in earnings in
the subsequent years. Also the firms that increase their dividends in year 0, has a
positive change in earnings in the next two years. One more interesting conclusion
one can draw from this panel is how flexible the firms seem to be. If the firms
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have more money, they pay out more, and the opposite if the firms have less
money.
In panel b we have scaled the change in earnings on the book value of equity. The
firms that do not change their dividends in year 0 have a positive change in
earnings in the dividend change year of 3 percent, and experience an increase in
earnings in the two years after the dividend change year. Dividend decreasing
firms tend to have a decline in earnings in year 0, but a positive change in
earnings in the two subsequent years. Finally we observe that firms that increase
their dividends experience an increase in earnings in the same year, but in the two
subsequent years they experience respectively -1 percent change and +1 percent
change.
A second analysis that can shed light on the future performance of firms after a
dividend change is done by measuring the changes in ROA for the 3 years prior
and the 3 years after the dividend change year (year 0). We would expect to see
average yearly change in ROA in the period 1 to 3 (lead) to be higher than for the
period -1 to -3 (lagged), if future performance improves after a dividend increase.
In table 6, panel a, dividend increases are analysed and in panel b dividend
decreases.
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The mean firm which increases its dividends experiences a yearly average drop of
1,32 percent in the three years following a dividend increase, whereas prior the
change they experience a yearly average increase of 0,68 percent. The lead minus
lagged ratio is at -1,98 percent, and is significant at the 1 percent level. This
confirms the results that future performance seems to be declining for dividend
increasing firm. For dividend decreasing firms a similar pattern emerges, i.e.
changes in ROA are positive prior to the dividend decrease, then performance
drops and ROA is decreased. By analysing the lead minus lag ratio at -1,56
percent, which is significant at the 1 percent level, the declining performance is
documented.
According to Altstadsæter and Fjærli (2009) the signalling view on dividend
originated with Lintner (1956). Lintner surveyed management of corporations and
his results indicates that management only increase dividends if they are sure they
are able to sustain them at the new and higher level. Grullon, Michaely and
Swaminathan (2002) note that a firm can have permanently higher ROA after the
dividend increase, as predicted by Lintner (1965), and at the same time they
experience “a decline in ROA during years +1 to +3 if the ROA in year 0
temporarily overshoots its higher permanent level” (2002, 397). In order to
analyse if this property holds in our sample, and thus drives the results in table 6
we analyse the level of ROA in the three years prior to the dividend change and
the three years after the dividend change directly. The theory predicts that the
ROA in the three years after the dividend change should be significantly higher
that the ROA in the three years prior to the dividend change.
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In table 7 the results from this analysis are presented. In panel a the result for the
dividend increasing firms are presented. Here a pattern emerges in most of the
years in which ROA first increase from year -3 until year 0, and then is reduced as
time goes by emerges. However the reduction in the years afterwards is not as
large as the increase in the years prior to the change. This is confirmed by
analyzing the three-year average lead group minus the three-year average lag
group; which leads to a value of 0,55 percent indicating that on average a firm has
0,55 percent higher ROA after a dividend change. This value is statistical
significant at the 1 percent level. In conclusion the firms that increases their
dividends do seem to have a permanently higher level of ROA.
In panel b the analysis is repeated for the group of firms that decrease their
dividends. The pattern that emerges here is quite different, and confirms the
results from table 7 panel b. First the ROA seems to be increasing in the years -3
to -1, but then sustains a rather sharp drop before it remains fairly stable in the
years 1 to 3. By analysing the lead minus lag ROA we confirm that these firms
seem to be experiencing a permanent drop in their ROA of 1,33 percent on
average, again this value is significant at the 1 percent level.
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Preliminary conclusions
The results from the preliminary analysis are mixed; from the descriptive statistics
it seems that the firms with positive dividends events are the one with best future
performance. This picture is confirmed by analyzing the changes and levels of
ROA in the 6 years surrounding the dividend change, where we found evidence to
support the hypothesis that managers only increase dividends if they believe that
they do not have to reduce them in the near future. In the same analysis it seems
that the firms that decrease their dividends experience a significant lower
permanent ROA. However when analyzing the changes in results as defined by
our two measures we find a reversal effect for the dividend-decreasing group, i.e.
in the dividend decrease year the result is reduced but in the two subsequent years
results are increasing.
In order to establish clearer results we will in the next section proceed with a
multivariate regression analysis with changes in results as the dependent variable
and dividend groups as explanatory variables.
Methodology
As is clear from the previous section the results regarding future profitability for
dividend changing firms are mixed. In this section we will employ multivariate
regression analyses in order to analyse the relationship more thoroughly. The
regressions employed in this paper are inspired by those of Nissim and Ziv (2001)
however extra control variables are added and the equations are modified slightly
in order to be compatible with data on private non-listed firms.
The scope of this paper is to analyse the effect of a dividend change on concurrent
and future earnings, for this reason the no-change group is not included in the
regressions. In addition the initiation and omission groups are excluded from the
sample, this is in line with other research in the field. For instance Nissim and Ziv
(2001), and Grullon, Michaely and Swaminathan (2002) both exclude initiations
and omissions from their sample. With only increases and decreases the focus is
on the dividend events that are most relevant for the typical firm, and thus the
sample size is 96 206 firm-years. Dividend omissions and initiations are discussed
in separate papers; see for example Michaely, Thaler and Womack (1995) or
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Healy and Palepu (1988). These papers often apply strict criteria in order for a
dividend event to be included as an initiation or omission. For instance Haely and
Palepu (1988) define a dividend initation as “the first dividend in a firm’s history
or the resumption of a dividend after a hiatus of at least ten years” (1988, 152)
and a dividend event as an omission if “they omit dividends for the first time in
their history or after paying dividends continuously for at least ten years”. (1988,
153) Applying such filters to the data used in this paper is not possible due to our
limited sample length.
The regressions used are:
For
t=0: Rest - Rest−1
B−1
= α0 + β1Div0DPC0 + β2Div0DNC + β3ROEt−1 + β4Sizet−1 + β5Leveraget−1 + β6Casht−1 +
β7GrowthOptt−1 + β8PctEquityLargestOwnert + β9FractionEquityPersOwnert + εt
For t>0: Rest - Rest−1
B−1
= α0 + β1Div0DPC0 + β2Div0DNC + β3ROEt−1 + β4Sizet−1 + β5Leveraget−1 + β6Casht−1 +
β7GrowthOptt−1 + β8Res0 - Res−1
B−1
+ β9PctEquityLargestOwnert + β10FractionEquityPersOwnert + εt
Hypotheses
In order to test the information content of dividend hypothesis we analyse the
results from the two regressions above. The information content of dividends
hypothesis states that dividend changes trigger stock returns because they contain
new information about future earnings of firms. With our sample of non-listed
firm it is impossible to test the effect of dividend changes on stock returns, but we
can test directly for its effect on future earnings changes. Whit the regressions
presented above, the hypotheses are:
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The first hypothesis states that dividend increases should be accompanied by
positive result changes in the dividend change year and the two following years.
The second hypothesis states that for dividend decreases negative changes in
results in the dividend change year and the two following years should occur. The
regressions are done for t=0, t=1 and t=2, were year 0 is the dividend change year.
With the results from these regressions it is possible to get a stronger indication of
how much a dividend change in year 0 can explain the change in results in the
same year, as well as the two subsequent years.
Control variables
Since it is likely that others factors than dividends have an effect on the change in
results of a given firm we include several control variables. First the return on
equity is included, since it has been shown by Freeman, Ohlson, and Penman
(1982) to be an important predictor of the changes in earnings. As Nissim and Ziv
(2001) explains in their article:
…they show that since ROE is mean reverting, high (low) ROE implies an
expected decrease (increase) in earnings. Since dividend changes are positively
correlated with current ROE, the expected change in earnings is likely to be
negatively correlated with the dividend change. Hence, a lack of correlation
between earnings changes and dividend changes would actually indicate that
dividend changes are informative about future earnings (Nissim and Ziv 2001,
2117).
In addition to this we also control for firm size, defined as the logarithm of
revenues. Many scholars find that firm size have an effect on firm performance,
both negative (Haines 1970, and Evans 1987) and positive (Gale 1972, and
Shepherd 1972), hence we control for this variable in order to isolate its effect on
firm performance. Further corporate governance theory predicts that degree of
leverage influences firm performance through its effect on agency costs (Berger,
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di Patti 2002), thus we control for this and are able to isolate the change in firm
result due to degree of leverage. Leverage is defined as a firm’s debt-to-equity
ratio. Finally a measure of how much cash a firm has and a measure of growth
options are included. It is possible that both growth options and the amount of
cash can affect the results, hence we control for these effects.
The variables are defined as follows:
Empirical Findings:
In this section we will present (please refer to table 8) the results from the two
regressions presented above. In table 8 the results for t=0 (panel a), t=1 (panel b)
and t=2 (panel c) are presented. In order to correct for possible heteroskedasticity
we use White robust standard errors (White 1980). Since the White robust
standard errors will be approximately equal to the “normal” standard errors in the
absence of heteroskedasticity (White 1980), we employ these in our analysis.
After using the White robust standard errors we can, with higher certainty, state
that our regression estimators are reliable in the presence of outliers.
In panel a we observe the results when t=0. In the dividend change year the
dividend increase variable has a significant and positive impact on changes in
revenues for all the years. This strong concurrent effect between dividend changes
and result changes are consistent with other findings. The dividend decrease
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variable, on the other hand, varies from being significant and insignificant, and
between having a positive and a negative sign. From these results it is difficult to
draw valid inferences. Moving to panel b, and t=1, we can note the number of
years in which the variable dividend increase is significant is reduced to only 5
years. In addition to this the sign is negative in three out of the five years.
Investigating the dividend decrease variable leaves us with even less significant
results. Only in 4 years the variable is significant, and in only two of these the
variable has a negative sign. Based on these results it is again difficult to draw
valid inferences regarding both the dividend increase and the dividend decrease
variable.
Finally in panel c the results when t=2 are presented. The results turn more
significant for both the dividend increase and the dividend decrease variable. In
five out of nine years the dividend increase variable is both significant and
positive. When it comes to the dividend decrease variable, the variable is
significant in seven out of nine years, and only one out of these seven has a
positive sign. From this panel it seem to be a positive correlation between a
dividend increase and changes in earnings two years into the future, and a
negative correlation between an dividend decrease and changes in earnings two
years into the future.
One important factor to keep in mind when interpreting these results is the
temporary tax reform of 2001 and the permanent reform of 2006. In the year for
which these reforms increase the tax on dividends, i.e. 2001 (temporary) and 2006
(permanent), we would expect to see a reduction in dividends; hence the results
for the decrease group in 2000 and 2005 can at least partly be driven by tax
considerations. The reform of 2001 was not announced so its effect on dividend
changes prior to 2001 should be zero. The 2006 reform, however, was announced.
As discussed this can have weakened the relationship between dividends and
earnings in the year leading up to the reform.
From table 8 we can also analyze the effect from the other control variables on the
dependent variable, change in earnings. Leverage seem to have a negative impact
on future earnings changes, meaning that when a firm increases its leverage future
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earnings should decrease. Cash do also seem to have a significant effect on future
earnings. But when it comes to cash, the effect seems to be positive; hence higher
relative cash holding is positive correlated with a future increase in earnings. The
variable Size seems to be more ambiguous when it comes to its effect on future
earnings. Our results give us both negative and positive coefficient values, and in
addition the coefficients are both significant and insignificant. The return on
equity is significant and negative in almost all years and in when t is zero, one and
two. This is consistent with the results in Nissim and Ziv (2001) and their mean
reversion story. The variable controlling for growth options is also significant and
positive in almost all years, when t is zero, one and two. We also controlled for
earnings change in the dividend change year, which is significant and negative
when t=1. But when t=2 the results gets more ambiguous; hence it is difficult to
draw valid inferences from these results.
Finally we also control for the different ownership structures of the firms. As we
can see from table 8, the variable percentage equity of the largest owner seems to
have a negative impact on the future change in earnings. The other ownership
variable, fraction of equity held by personal owner is only significant in a few
years for all t values. The results are therefore ambiguous when it comes to this
variable; hence it is difficult to draw valid inferences regarding the impact from
the ownership structure on the change in earnings.
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Conclusion
In this paper the effect of changes in dividend policy on future firm performance
for non-listed firms is analyzed. As discussed in the literature review there are
many different findings and theories on this area. The main aim of this paper has
been to replicate the findings of Nissim and Ziv (2002), in which “strong evidence
in support of the information content of dividends hypothesis” (pp. 2131) is
presented, for non-listed firms. Based on their research we would expect to see
some of the same patterns in our research.
In order to establish some basic knowledge regarding the relationship in this
sample univariate analysis is employed. The measures of performance used in this
analysis are return on assets, return on equity and changes in results. With this
analysis we find some evidence for the Lintner hypothesis, in which firms
increase their dividends only when earnings are expected to increase permanently.
Further the findings in this section indicate that listed and non-listed firms are
different when it comes to dividend policy. We have been able to establish that
non-listed firms are highly flexible in their dividend policy, changing it rather
frequently. This is consistent with other findings on non-listed firms. Listed firms
tend to engage in smoothing of their dividends, at least partly due to the scrutiny
of public capital markets (Michaely and Roberts 2006). For non-listed firms this
scrutiny does not exist and higher flexibility is possible.
Finally the information content of dividends hypothesis is investigated, over the
time period 2000 till 2008, through multivariate regression analysis. This
hypothesis states that dividend changes trigger stock returns because dividends
contain new information about firm’s future profitability. In order to test this we
have done some alternations to the regressions, but the main elements are the
same. Our results, however, do not lend much support for the information content
of dividends hypothesis. The multivariate regressions give mixed evidence,
especially for the first year after the dividend change. In the second year after a
dividend increase (decrease) the results indicate that firms experience positive
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(negative) changes in earnings. After employing different techniques and
variables in our analysis the result are found to be robust.
Limitations and Further Research
An important limitation to this paper is the period for which the data is sampled.
First the sample horizon is rather short, compared to other samples in the
literature, with 8 years of data. Second and most importantly there have, as
discussed, been two tax reforms during the sample period, one that introduced
dividend taxation only for a year (2001) and a permanent shift to taxation of
dividends in 2006. These reforms will, as discussed, have affected our results,
possibly weakening the relationship between dividends and earnings, thus our
results may be constricted to be valid only within its period and may possibly not
be generalized. More research is therefore needed on “normal” times without
major reforms in taxations of firms in order to be able to present firm conclusions
regarding the signalling hypothesis.
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References: Alstadsæter, Annette and Fjærli Erik, 2009. “Neutral Taxation of Shareholder
Income? Corporate Responses to an Announced Dividend Tax” CESifo Working
Paper no. 2530, jan 09.
Benartzi, Shlomo; Roni Michaely and Richard Thaler. 1997. “Do Changes in
Dividends Signal the Future or the Past?” The journal of Finance, 52(3): 1007-
1034.
Berger, Allen N. and di Patti Bonaccorsi Emilia. 2006. “Capital Structure and
Firm Performance: A New Approach to Testing Agency Theory and an
Application to the Banking Industry”. Journal of Banking and Finance, 30(4):
1065 - 1102.
Bhattacharya, Sudipto. 1979. “Imperfect Information, Dividend Policy, and "the
Bird in the Hand” Fallacy” The Bell Journal of Economics, 10(1): 259-270.
Evans, David S. 1987. “The Relationship Between Firm Growth, Size and Age:
Estimates for 100 Manufacturing Industries”, Journal of Industrial Economics,
35(4): 567-582
Fama, Eugene F. and James D. MacBeth. 1973. “Risk, Return and Equilibrium:
Empirical tests”. The Journal of Political Economy, 81(3): 607-636.
Freeman, Robert N., James A. Ohlson, and Stephen H. Penman. 1982. “Book
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Journal of Accounting Research, 20: 639-653
Gale, Bradley T.1972. “Market Share and Rate of Return”, Review of Economics
and Statistics, 54(4): 412-423.
Grullon, Gustavo; Roni Michaely and Bhaskaran Swaminathan. 2002. “Are
Dividend Changes a Sign of Firm Maturity?” The Journal of Business, 75(3): 387-
424.
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Grullon, Gustavo; Roni Michaely; Shlomo Benartzi and Richard Thaler. 2005.
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Business, 78(5): 1659-1682.
Haines W.W. 1970. “The Profitability of Large-Size Firm”, Rivista Internationale
de Science Economiche e Commerciale, 17: 321-351.
Healy, Paul M. and Krishna G. Palepu. 1988. “Earnings Information Conveyed by
Dividend Initiations and Omissions” Journal of Financial Economics, 21:149-175
Jensen, Michael C. 1986. “Agency Costs of Free Cash Flow, Corporate Finance,
and Takeovers” The American Economic Review, 76(2): 323-329
Kose, John and Joseph Williams. 1985. “Dividends, Dilution, and Taxes: A
signaling equilibrium” The Journal of Finance, 40(4): 1053-1070.
Lintner, John. 1956. “Distribution of Incomes of Corporations among Dividends,
Retained Earnings, and Taxes”. American Economic Review, 46:91-113
Michaely, Roni; and Michael R. Roberts. 2007. “Corporate Dividend Policies:
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to Dividend Initiations and Omissions: Overreaction or Drift?” The Journal of
Finance, 1(2): 573-608.
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Information” The Journal of Finance, 40(4): 1031-1051.
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Organization for Economic Co-operation and Development. 2008. ”OECD
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Appendix; Preliminary thesis:
I. Introduction
In the literature regarding dividend payout policy many theories suggests that
changes in dividends contain some information regarding the future profitability
and earnings of the firm. More precisely many of these theories predict that
dividends are positively correlated with future profitability and earnings. One such
theory is the signalling hypothesis, which is based on information asymmetry
between managers and investors (e.g Bhattacharya 1979, and Miller and Rock
1985). With this asymmetry they claim that dividends are used as explicit signals
about future earnings which the management sends out intentionally and at some
cost to the investors. According to Bhattacharya (1979) the signalling cost stems
from the fact that dividends are taxed at a higher rate than capital gains
(Bhattacharya 1979). Miller and Rock (1985), however, views the loss of funds to
use in investments as the major signalling cost.
Kose John and Joseph Williams (1985) also identifies a signalling equilibrium
were private information is revealed by taxable dividends. In their model insiders
distribute larger dividends when their information is more valuable. According to
the authors this will push up the price of the stock when the demand for cash by
their current stockholders and the firm exceeds its internal supply for cash.
The signalling hypothesis have been widely researched, however there are
contradictory findings in the literature. Some studies give support for the
signalling hypothesis (Nissim and Ziv 2001, Bhattacharya 1979), while others
finds no or limited support for it (Grullon et al. 2005, Benartzi et al. 1997).
This preliminary thesis report is set up as follows; first a section on motivation of
the subject and intentions with the research, then a literature review before we
continue with our planned methodology and a brief description of the data.
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II. Motivation and intentions
Stock markets and investor behaviour suggests that dividends have information
content. When dividends are increased a firm’s stock price tends to increase and
vice versa when dividends are cut (e.g. Grullon et al. 2002). A prediction of the
dividend signalling hypothesis is that dividend changes are positively correlated
with future changes in profitability and earnings, hence these share price
movements are observed. According to Grullon et al. (2005) this is one of the
most important issues in corporate finance, hence it is of interest to investigate the
information content of dividends. This is a task which has been pursued by many
scholars; and so far no definite agreement has been reached.
Most of the research which has been done on this subject so far has employed data
from listed companies. We, however, will investigate the relationship between
dividends and future firm performance for private companies in Norway. In this
way we have most of the framework in prior work, but the research will be done
on data that has not been researched extensively. This research can yield
interesting results and possibly add new insights to the debate about the
relationship between dividends and future earnings.
We have chosen to define the scope of the research problem broader than just
dividend changes effect on future earnings, and instead focus on firm performance
in a wider sense. This allows us to asses if dividends have an effect beyond just
earnings. We can therefore analyze the effect of dividend changes on investments,
return on assets, cash flow, research and development and so forth.
A normal assumption is that information asymmetries are a bigger problem for
small and unlisted firms, which can imply support for the signaling hypothesis.
However it can also be tempting to believe that there is no strong correlation
between the change in dividends and the change in future earnings for private
firms. A first argument is the Modligiani and Miller irrelevance theorem which
states that firm value is independent of finance structure, from which it follows
that investors are indifferent to if dividends are paid out or if earnings are
reinvested profitably. Another argument could be that the management in many
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cases is the actual shareholders, but in the cases with outside shareholders they are
often very “close” to the management. The fact that to use dividends is a costly
signaling-strategy could induce the management of private firms to choose
another strategy. In fact, in many cases they do not need to signal since insiders
and outsiders are the same persons. Our research will therefore give us an
interesting, and useful, indication on how firms use dividends, and which of the
two stories we gain support for.
III. Literature review
There exists an extensive literature on this field, and we will in the following
review some of the most important papers. One of the first classical signaling
paper is “Imperfect Information, Dividend Policy, and “The Bird in the Hand”
Fallacy” from 1979 by Sudipto Bhattacharya. The paper develops a theoretical
model in which dividends function as a costly signal for expected future cash
flows. Hence changes in dividends should convey information about future cash
flows. It follows that dividend decreases are bad news (lower future cash flows)
and dividend increases are good news (higher future cash flows). The author
develops these results by assuming that outside investors have imperfect
information about firm’s profitability, and that cash dividends are taxed at a
higher rate than capital gains. The fact that dividends are taxed at a higher rate is
the major signaling cost which leads dividends to function as a signal.
In the model outside investors cannot distinguish the profitability of productive
assets held by firms, and existing shareholders care about the market value of the
firm assigned by outsiders. Investors ignore other sources of information than
dividends on the ground that they are “fundamentally unreliable screening
mechanisms because of the moral hazard involved in communicating
profitability” (Bhattachary, 1979: 260). It follows that the communication of even
ex post cash flows from existing assets is costly, because only dividends can
convey this information and dividends are taxed higher than capital gains. From
this Bhattacharya concludes that dividends can function as an explicit signal about
future earnings, sent intentionally and at some cost by the management to the firm
and its stockholders.
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Merton Miller and Kevin Rock wrote a paper in 1985 where they looked at the
dividend policy of a firm when information is asymmetric. We know that when
there exists asymmetric information the state of the information with respect to
earnings, investment and net dividends are different for insiders and outsiders.
For an outsider the most important piece of public information is the dividends,
hence this is very important when it comes to the valuation of a firm. Since an
insider has information about unannounced earnings, this will lead to a difference
in the perceived value of the firm. The model, which is developed in this paper,
therefore proposes dividends as a signal to outsiders on how insiders view the
economic future of the firm. For the firm, this is a costly way of communicating.
This is in accordance with Bhattacharya (1979); however Miller and Rock view
the major signaling cost as the loss of funds to use in investments. Because of this
cost, this kind of signaling only makes sense for the good-news firms, and not the
bad-news firms. It is only for the good-news firms that the cost may be worth
bearing to avoid giving the market a false impression that earnings were not high
enough to justify a dividend.
Kose John and Joseph Williams (1985) propose a signaling equilibrium which
actually has a very simple intuition. A firm must either retire fewer outstanding
shares or issue new shares in order to raise funds for investments. As firms,
current stockholders have to sell existing shares to raise cash on personal account.
If either of these events occurs current stockholders will suffer some dilution in
their fractional ownership of the firm. When inside information is more favorable,
the reduction of this dilution is more valuable for the current stockholders.
“Consequently, insiders, acting in the interests of their current stockholders, may
distribute a taxable dividend if outsiders recognize this relationship, bid up the
stock price, and thereby reduce current stockholders' dilution. In the resulting
signalling equilibrium, insiders control dividends optimally, while outsiders pay
the correct price for the firm's stock.” (Kose John and Joseph Williams, 1985:
1054). In this equilibrium, insiders with truly more valuable future cash flow will
distribute larger dividends and receive higher prices for their stock, whenever the
demand for cash by both the firm and its current stockholders exceeds its internal
supply of cash. Thus, John and Williams (1985) develops a model were there
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should be, at least in theory, a positive relationship between an increase in
dividends and future cash inflow.
There are many scholars who have tried to empirically document a correlation
between dividend changes and future firm performance, e.g. the signaling
hypothesis. Shlomo Benartzi, Roni Michaely and Richard Thaler analyses this in
their article “Do Changes in Dividends Signal the Future or the Past” (1997). In
their article the authors utilize a large number of firms and events and they control
for many factors that possibly could create a spurious relationship between
dividends and subsequent earning changes. Their results, both by utilizing
categorical analyses and regression analyses, indicate a very strong correlation
between dividend changes and lagged and contemporaneous earnings. However,
they are unable to find much evidence of a positive relationship between dividend
changes and future earnings changes.
Because of their findings the authors ask if dividend changes signal something
else than the expected value of future earnings. One possibility is that dividend
increases are a signal about a permanent shift in earnings (as Lintner (1956)
suggests). They do indeed find some support for Lintner’s view. Nevertheless,
their results lead them to conclude that “if firms are sending a signal, (a) it is not
a signal about future earnings growth and (b) the market doesn’t “get it”. Why
firms would burn money to send a signal that is not received is, indeed, a
mystery.” (Benartzi et al, 1997; 1009).
Unlike Benartzi et al. (1997) Nissim and Ziv (2001) present the “information
content of dividend hypothesis”, which they claim tell us that dividend changes
trigger stock returns because dividends convey new information about the firms’
profitability. Investigating this hypothesis Nissim and Ziv (2001) find a positive
relationship between dividend changes and future earning changes, future
earnings and future abnormal earnings. Further they find that dividend increases
are positively related to earnings in each of the four subsequent years, but that a
dividend decrease is not related to future earnings.
As they explain in their paper, the lack of correlation between dividend decreases
and future earnings does not necessarily imply that dividend decreases are not
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informative about future earnings. Actually, when they omit current year earnings,
the coefficient on dividend decreases becomes positive and significant. This can
be explained by accounting practices. Losses should be recognized in earnings
when anticipated whereas profits should be included only when earned. As a
result, current year earnings cannot contain the future implications of the good
news that caused management to increase dividend. On the other hand, future
implications of the bad news that triggered the dividend decrease should be
reflected in current earnings.
In another article “Dividend changes Do Not Signal Changes in Future
Profitability” by Gustavo Grullon, Roni Michaely, Shlomo Benartzi and Richard
Thaler (2005), the signaling hypothesis is rejected. In this paper the authors claim
that Nissim and Ziv’s (2001) assumption of linear mean reversion in earnings is
inappropriate. From econometrics we know that assuming linearity when the true
functional from is nonlinear has the same consequences as omitted variable bias.
Hence they argue that the Nissim and Ziv results may be biased.
The authors therefore employ a model which assumes that the rate of mean
reversion and the coefficient of autocorrelation are highly nonlinear. With this
approach the relation between dividend changes and future earnings disappears.
Overall they find no evidence supporting the idea that dividend increases signal
better prospects for firm profitability. They also show that out of sample forecasts
are generally better without using dividend changes as an independent variable.
They claim that given the evidence presented in their article and others it is
sensible to conclude that changes in dividends are not useful in predicting future
changes in earnings. However they do not rule out that dividend increases signal
something, “but that something is neither abnormal increases in future earnings
nor abnormal increases in future profitability” (Grullon et al, 2005: 1681).
The literature continues to try to establish what exactly dividends are a signal of.
In the article “Are Dividend Changes a sign of Firm Maturity” by Grullon, Roni
Michaely and Bhaskaran Swaminathan (2002) they try to answer this question.
From this article and others we have indications that dividends contain
information (market reactions). Further, by definition fundamental news about a
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firm has to be either about its cash flows or its discount rate. The authors claim
that since it is not news about cash flows it must be about the discount rate. They
document by using data on US stocks that firms which increase (decrease)
dividends experience a significant decline (increase) in their systematic risk, i.e. a
reduction in the discount rate.
On the basis of their findings the develop a new hypothesis, the Maturity
Hypothesis which states that dividends contain information about firms transitions
in life cycles to a more mature phase. As firms become more mature they tend to
increase their payouts due to less positive net present value opportunities. Hence
we should expect dividend increases to be associated with a subsequent declining
profitability, risk and return on investments which will lead to lower capital
expenditures. This hypotheses is connected with the Free Cash Flow hypotheses
developed by Jensen (1986), however the Free Cash Flow hypotheses does not
contain any explicit prediction concerning changes in risk, hence it cannot be the
complete story.
In order to test this hypothesis the authors investigates different aspects of firm
performance employing various techniques we also can use. First they analyze the
changes in Return on Assets (ROA) and dividend payout ratios. Dividend payout
ratios are interesting because “if cash flow signaling models are correct, the
payout ratio of a dividend increasing firm should increase temporarily at first and
then decline gradually over time as earnings start to catch up with the increased
dividends” (Grullon et al. 2002; 402). Two final variables they investigate are
capital expenditure and excess cash. The free cash flow hypothesis suggests that
dividend increasing firms ought to decrease (at least keep constant) their capital
expenditures. In addition we would expect to see their cash balances decline. This
is something we can analyze and see whether this hypothesis holds in our sample.
Overall their findings support the Maturity Hypothesis and fills in the pieces
providing more content to the Free Cash Flow hypothesis.
In our paper, the data is on private firms, unlike most of the research done on the
area. Michaely and Roberts (2007) compare the different dividend policies
between public and private firms, and try to explain why private firms may have a
different dividend policy than public firms. In this paper, the authors divide their
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data sample of UK-firms in three distinct groups; wholly owned firms, private
dispersed firms and public firms.
As stated by Michaely and Roberts (2007), an important difference between a
private- and a public-firm is the ownership structure. Some private firms exhibit
little, if any, separation between control and ownership. If there should exist
outside shareholders, then they are often close family members, or informed and
active monitors, such as corporation with close ties to the firm. This will affect the
dividend policy of the firm. Some private firms may for instance increase
dividend payments not as a signal to shareholders, but maybe instead of wages
due to tax reasons, although the paper by Michaely and Roberts (2007) do not find
evidence of this in their data.
The paper presents three hypotheses, where the last hypothesis possibly is the
most interesting for our work. This hypothesis is as follows:
“Hypothesis 3: Following dividend increases, operating performance should
improve for Private Dispersed firms and Public firms, but there should be little or
no relation between dividend increases and operating performance for Wholly
Owned firms.” (Roni Michaely and Michael Roberts; 2007; 25).
For our work this is very interesting. What the hypothesis suggests is that the
firms which increase their dividends are those that are undervalued by the market.
When they test this hypothesis they come up with two conclusions. Under
symmetric information, firms will not try to signal future change in earnings with
an increase in dividends. This is of course natural since outsiders have the same
information as insiders. But, even when information is asymmetric, they find no
evidence that firms try to signal higher future earnings with an increase in
dividends. Hence, they reject the signaling hypotheses in contrast to Nissim and
Ziv (2001). As explained, the empirical work on the area is highly debated.
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IV. Methodology and Data
As the previous sections shows there exists an extensive literature on this field of
research, with different methodologies and conclusions. We will pursue some of
the methodology used by the authors mentioned in the literature review. However
since we use a different data set, and most importantly that we do not possess data
on market values and stock prices due to our interest in private firms, we will have
to adjust the previously employed methods.
A large part of our methodology is based on the work by Nissim and Ziv (2001).
One of the first regressions we will apply on our data is the following:
Where
- Et: Earnings in year t.
- B-1: Book value of equity at the end of the previous year prior to the
dividend change.
- RDIV0: The annual percentage change in the cash dividend payment in
year 0.
- ROEt-1: Earnings in year t-1 scaled on the book value of equity at the
end of year t-1.
The result from this regression will indicate whether dividend changes are
informative about future earnings changes or not. If dividends contain any
information about future earnings, we expect α1 to be significant.
To examine whether dividend changes contain information of future earning
changes, incremental to the earning changes in the year of the dividend change,
we include, as done by Nissim and Ziv, an additional control variable;
, hence regressing the following model (were DPC (NPC) is a
dummy variable that equals one for dividend increases (decreases) and zero
otherwise):
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We would expect that if a change in dividends conveys some information about
future change in earnings then β1P and β1N would be significantly different from
zero.
To ensure the robustness of our results we will include some additional control
variables to the original equations of Nissim and Ziv. Such controls can be year
and industry effects. In addition we would like to control for financial constraints,
but because of endogeneity problems with financial constraints we will have to
measure it by a proxy, e.g. leverage.
As Nissim and Ziv we now want to extend our analysis, and examine the relation
between dividend changes and the level of earnings in the years following the
dividend change year. To investigate the relationship between a dividend change
and both future earnings and future abnormal earnings (AE) can for us as well be
informative. Because of this we want to examine the following two regressions:
Nissim and Ziv have included the market value of equity, denoted as P-1 in the
regressions above. For us this is obviously impossible to get hold of, so if we are
going to employ this methodology we have two options, either regress the
equations without controlling for this, or we could see if we can find a proxy for
the market value of equity. The reason why Nissim and Ziv include this factor is
to control for information of future profitability. Therefore we do not need to find
a proxy for the market value of the equity per se, but a proxy for the information
of future profitability. A proxy for this could be future growth opportunities
measured by lagged sales over assets.
As an alternative to the pooled regression done by Nissim and Ziv we can do
yearly regressions and average the coefficients to see if the results differ
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substantially. This methodology was originated in Fama and Macbeth (1973) and
has also been used with success in the dividend literature.
Another way to analyze the effect of changes in dividends on future earnings is to
tabulate the earning surprise in year 0,1 and 2 following a change in dividends;
this methodology is used by Benartzi et. al. (1997). In order to employ this
method we have chosen three different measures of earnings surprise.
1) To establish a baseline we will use a simple measure of earnings
surprise:
2) Annual percentage change in earnings (Benartzi et al. 1997), scaled by
book value of equity.
3) Comparison of the dividend changing firms with the non-dividend
changing firms in the same industry (Benartzi et al. 1997):
Where n=1, 2,…,N are the firms that did not change their dividends in
year t and are in the same industry.
We can then follow the evolution for earnings of groups of dividend decreasing,
no-change and increasing firms for the different measures of earnings surprise,
and analyze if there is any systematic pattern in the development of these.
As a final approach we will investigate the connection between dividend changes
and other measures of firm performance such as return on assets (ROA), capital
expenditures and cash holdings, and payout ratios. This is done by Grullon et al.
(2002), and the analyses discussed below draws heavily on that paper.
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First we can compare the average changes in ROA, defined as operating income at
time t on total assets at time t, for the years -3 to -1, 0, and 1 to 3. Then analyze
the average return for the years 1 – 3 minus the average return for the period -3 to
-1, and finally the average return for the years 1 – 3 minus the return in year 0. It
is also possible to correct for industry specific factors and previous performance
and then analyze the results. All these analyses are done for different quintiles of
dividend changing firms, and again if dividends contain information about future
ROA we would expect a significant positive correlation between ROA and
dividend changes. It could be that a dividend signals a permanent increase in
current ROA instead of an increase in future ROA. This would then suggest that
future ROA should be higher than past ROA, at the same time there could be a
decline in years 1 to 3 if the ROA in year 0 temporarily overshoots its higher
permanent level. To ensure that the changes in ROA are not driven by this effect
we must also analyze the level of ROA.
Another factor which will be interesting to analyze is dividend payout ratios,
defined as dividends paid over net income. If cash flow signaling models are
correct, the payout ratio of firms which increases its dividend should increase
temporarily before it gradually declines as earnings increase. Finally the Free
Cash Flow hypothesis states that firms which increase their dividends should
decrease (or at least not increase) their capital expenditures. We will also expect
that their cash balances decline since they have chosen to pay out their excess
cash as dividends.
IV.I. Data
We have gained access to the Centre for Corporate Governance Research database
(CCGR) and have obtained a host of different corporate variables for Norwegian
private firms. Specifically we have data on 20 variables mostly consolidated
account data but also data concerning ownership control and industry codes. For a
description of the different variables included in the dataset please see appendix I.
The data is on a yearly basis from 1994 until 2007, further it is on panel form with
one firm for the entire time period, then the next firm for the entire period and so
forth. This dataset will allow us to investigate relationships between different
factors of firm performance such as return on assets, earnings, capital
expenditures, amount of cash and dividends.
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V. References:
Benartzi, Shlomo; Roni Michaely and Richard Thaler. 1997. “Do changes in
dividends signal the Future or the Past?” The journal of Finance, 52(3): 1007-
1034.
Bhattacharya, Sudipto. 1979. “Imperfect information, dividend policy, and "the
bird in the hand” fallacy” The Bell Journal of Economics, 10(1): 259-270.
Fama, Eugene F. and James D. MacBeth. 1973. “Risk, Return and Equilibrium:
Empirical tests”. The Journal of Political Economy, 81(3): 607-636.
Grullon, Gustavo; Roni Michaely and Bhaskaran Swaminathan. 2002. “ Are
Dividend Changes a Sign of Firm Maturity?” The Journal of Business, 75(3): 387-
424.
Grullon, Gustavo; Roni Michaely; Shlomo Benartzi and Richad Thaler. 2005.
“Dividend Changes Do Not Signal Changes In Future Profitability” Journal of
Business, 78(5): 1659-1682.
Jensen, Michael C. 1986. “Agency Costs of Free Cash Flow, Corporate
Finance,and Takeovers” The American Economic Review, 76(2): 323-329
Kose, John and Joseph Williams. 1985. “Dividends, Dilution, and Taxes: A
signaling equilibrium” The Journal of Finance, 40(4): 1053-1070.
Lintner, John. 1956. “Distribution of incomes of corporations among dividends,
retained earnings, and taxes”. American Economic Review, 46:91-113
Michaely, Roni; and Michael R. Roberts. 2007. “Corporate Dividend Policies:
Lessons From Private Firms”
Miller, H. Merton and Kevin Rock. 1985. “Dividend Policy under Asymmetric
Information” The Journal of Finance, 40(4): 1031-1051.
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Nissim, Doron and Amir Ziv. 2001. “Dividend changes and future profitability.”
Journal of Finance, 56(6): 2111–2133.
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Appendix I