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.