Dividend policy and its impact on firm valuation


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Dividend policy and its impact on firm valuation
A study of the relationship between dividend policy and stock prices on the Swedish market

Master thesis within: Number of credits: Programme of study: Authors:
Advisor: Co-Advisor: Jönköping

Finance 30 ECTS Civilekonomprogrammet Adam Enebrand Tobias Magnusson Agostino Manduchi Toni Duras May 2018

Acknowledgements
The authors of this study would like to extend their gratitude to the various people that have been involved in the process of writing this paper. Throughout the semester, the feedback and support that has been given has been outstanding.
We would like to thank our advisor Agostino Manduchi for the thorough supervision and input that has significantly helped the writing of this thesis. Toni Duras also deserves a big thank you from the authors, his help and guidance throughout the statistical parts of this study has been excellent.
Lastly, we would like to extend our gratitude to our fellow students in the seminar group. The thoughts and ideas received has helped the authors to improve this thesis.

Adam Enebrand

Tobias Magnusson

Jönköping international Business School, May 2018

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Master’s thesis within Business Administration, Finance

Title: Authors: Advisor: Co-advisor: Date: Keywords:

Dividend policy and its impact on firm valuation Adam Enebrand & Tobias Magnusson Agostino Manduchi Toni Duras May 2018 Dividend policy, Firm performance, Ratios

Abstract
The issue of dividends and what role it plays, has been the subject of discussion for decades. The main reason for this is that the chosen dividend policy for a company affects several different stakeholders, with shareholders being the most affected party. Determining dividend policy is influenced by multiple factors such as capital structure, potential stakeholder signaling and corporate culture concerning payouts.
This study will investigate how the relationship between firm performance and stock price is affected by the level of dividends a firm pays. To explore this relationship, the authors will conduct a correlation and regression analysis that is performed on data collected on middle and large capitalization firms listed on the Stockholm stock exchange. The chosen time frame for this study is year 2007-2017. Several variables are included in the regression model in order to explore a potential relationship.
The findings of this study indicate that the stock price of high dividend yield firms are more dependent on financial performance compared to low dividend yield firms. However, an overall positive correlation is found between financial performance and stock price for both samples.

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Table of contents
Acknowledgements ......................................................................................................... ii

Abstract............................................................................................................................ ii

1 Introduction & Background ................................................................................... 1

1.1 Introduction...................................................................................................................... 1 1.2 Problem Discussion...........................................................................................................1 1.3 Purpose ........................................................................................................................... 3 1.4 Delimitations ................................................................................................................... 3

2 Theoretical framework ........................................................................................... 4

2.1 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.2 2.2.1 2.2.2 2.2.3 2.3 2.4

Measurement of firm performance..................................................................................... 4 Earnings.......................................................................................................................... 4 Ratios ............................................................................................................................. 5 Return on Equity.............................................................................................................. 5 This study ....................................................................................................................... 6 Limitations to ratios ......................................................................................................... 6 Dividends .........................................................................................................................7 Dividend relevance & irrelevance.......................................................................................7 Dividend & Payout Policy ................................................................................................ 8 Dividend & stock price volatility....................................................................................... 9 Dividend policy & firm risk ............................................................................................. 12 Asymmetric information & Signaling ...............................................................................13

3. Methodology........................................................................................................... 15

3.1 3.2 3.3 3.4 3.5 3.6 3.8 3.8.1

Approach ....................................................................................................................... 15 Gathering of data ............................................................................................................16 Validity & Replicability and Methodology evaluation ........................................................16 Data analysis and definitions............................................................................................ 17 Time period & Sample size.............................................................................................. 17 Descriptive Statistic ........................................................................................................19 Research method.............................................................................................................21 Correlation ..................................................................................................................... 21

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3.8.2 3.9

Regression model........................................................................................................... 22 Expected results & Hypothesis ........................................................................................ 22

4. Empirical Results................................................................................................... 25

4.1 Descriptive Statistics ...................................................................................................... 25 4.2 Pearson Correlation........................................................................................................ 25 4.3 Coefficients ....................................................................................................................27

5. Analysis................................................................................................................... 30

5.1 Correlation & Multicollinearity ....................................................................................... 30 5.2 Regression Output Analysis ............................................................................................. 31 5.3 Theoretical discussion on empirical results....................................................................... 35

6. Conclusion & Discussion....................................................................................... 37

6.1 Further Research & Implications ..................................................................................... 38 6.2 Ethical issues & Societal Implications ............................................................................. 39

References ...................................................................................................................... 40

Appendix........................................................................................................................ 45

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1 Introduction & Background
This chapter introduces the reader to the notion of dividend and firm performance. The intentions of this study are described and discussed in the problem and purpose section.
1.1 Introduction Dividend and how it affects the way investors evaluate stocks is a topic debated by many over a long period of time. The financial performance of a firm is essential to sustain and increase stock price and financial returns of investors. This paper investigates the dependency between stock price and firm financial performance and how that differs between firms with high dividend yield and low dividend yield stocks. The underlying idea is that different payout policies lead to different relationships between financial performance and stock price. Firms that cannot deliver expected financial returns should have a devaluation in stock price (Ross, Westerfield and Jordan, 2010). However, as discussed by (Brav et. al, 2005) firms are afraid of cutting dividends as the signaling effect will have a negative impact on stock price. According to this and the signaling effect, firms can manipulate the stock price and sustain a higher stock price than what the financial performance otherwise would produce. Therefore the authors intend to investigate if there is a difference between how the stock price and firm performance interact between high dividend and low dividend firms.
The financial performance will represent the performance of the firm and is measured using return on equity and gross profit margin. So far, the authors’ conception on how dividend and stock performance are interacting is unsatisfactory since limited research has been performed in this specific area, especially on the Swedish market.
1.2 Problem Discussion With this study, the authors aim to examine the dividend policy’s effect on how stock value responds to firm performance. More exactly, investigating whether or not stock price of firms that pay high dividends are more dependent on the reported financial performance than stocks with lower dividend. Excess capital can be paid as dividend to signal good financial health, which is referred to as the signaling theory. A survey produced by Brav et. al (2005) suggest that managers are reluctant to cut dividend even
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if that would be in the best interest of the firm, this is partly explained by the dividend signaling theory. Dividend irrelevance theory states that dividend has an impact on stock price as higher dividend produce a lower stock price. This is explained as equity that leaves the firm in the form of dividend and the stock value should be devalued with the same amount, making dividend irrelevant for the return of the stockholder. Dividend signaling suggest that dividend has a positive correlation with stock price and dividend irrelevance that dividend has a negative correlation with stock price. However, both theories suggest that dividend policy has an impact on stock price. Since both of these theories speaks for dividends potential to impact stock price, it would be interesting to investigate the dependency of stock price on financial performance and if the dependency is similar among firms with different dividend policies.
As argued by Ross, Westerfield and Jordan (2010) financial performance is the optimal way to evaluate stock price. Financial performance being and important factor for stock price is a notion argued by many, Chakravarthy (1986), Feltham and Ohlson (1995) Delen, Kuzey & Uyar (2013) are just a few of all the advocates for firm performance as the main drive of stock price. According to this, stock price should be strongly correlated and fairly dependent on financial performance. Therefore, financial performance should be one of the main variables when evaluating stocks due to this strong relationship. Even though financial performance and dividend policy is not the only factors to consider when evaluating stocks, these are the main variables investigated in this study.
However, as previously discussed there are both theoretical and practical arguments for why dividend have an impact on stock price. Managers can therefore use dividends as a tool to affect the stock price which in turn can lead to stock price deviance from the financial performance. This deviation can influence the ability to make an accurate estimate of the value of a stock for interested market actors. The level of dividend has an effect on how changes in dividend will impact the stock price, stock price of firms with higher dividend yield are more sensitive to changes in dividend (Bajaj and Vijh, 1990). Therefore, it can also make it difficult for managers to appreciate the impacts of dividend policy if dividend has an unexpected effect on how the stock is valuated on the market. This can lead to managers making inefficient decisions regarding dividends.
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The authors of this paper theorize that the price of stocks with lower dividend yield should be more dependent on firm performance as reported in the financial statements than those firms with higher dividend. This notion is based on the signaling theory, that high dividend produce a higher stock price. Therefore, stocks with lower dividend yield will be more dependent on the financial performance than the high dividend stocks while the high dividend stock are more dependent on dividend policy. 1.3 Purpose There has been an abundance of studies conducted regarding dividend policy over several decades since dividends have historically been a heavily debated subject. Several studies have been conducted that regards dividend policy and its effect on share price, both in Sweden and abroad. However, a consensus in the sense of the word has not been reached and to the authors’ best knowledge, a study that includes the aspect of firm performance has not been conducted. Through this research, the authors hope to further investigate the impacts of dividend partly to improve investor and management decisions in the future. Further, to contribute to the theoretical understanding of dividend and its potential impact. 1.4 Delimitations The thesis will only include large and medium capitalization companies listed in Sweden, more specifically listed on the Stockholm exchange. The thesis will exclude companies in banking and finance sectors, this exclusion is due to the industries special regulatory nature. Companies that were listed and delisted during the defined research period are removed from the sample. Companies in the sample that did not have enough information, were removed as they would significantly reduce the number of observable data in the sample when performing the regression.
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2 Theoretical framework
This chapter will introduce the reader to theories regarding firm performance, financial indicators, dividend & payout policies, signaling and asymmetric information as well as further theories in order to help the reader grasp and relate the empirical results and analysis.
2.1 Measurement of firm performance Firm performance in itself is a broad concept and can refer to several different aspects, depending on who you ask and what it is that is trying to be measured. It can refer to strategic performances such as customer satisfaction, employee satisfaction and CSR performance, however it can also refer to stricter financial performances such as profitability, growth or market value. Companies that can display a strong financial performance are by default more inclined to satisfy one of the most important stakeholders, namely investors and shareholders (Chakravarthy, 1986). Cho & Pucik (2005) argue that financial performance as a method to satisfy investors can be represented by the above mentioned aspects, profitability, growth and market value. Profitability is the term used when describing how well a company is able to generate returns (Glick, Washburn and Miller, 2005). Firms can definitely be valued based on information provided by financial reports. However, it is worth noting that noisy estimates are used for these valuation and therefore have an effect on the valuation process and the end result (Damodaran, 1999).
2.1.1 Earnings Earnings and revenue streams are further examples of easy and popular methods for investors to measure firm performance. Under the accrual basis of accounting, earnings are the summary measure of firm performance. In general, it can be said that, the success of a firm is dependent on its ability to generate cash flows (Dechow, 2018). Profitability then incorporates different measurements, or indicators, some of whom are used more frequently than others when assessing profitability. There are many advocates for using current earnings for cash flow measurements to predict future earnings with for instance Graham (1962), Kieso and Weygandt (1995) being a few of these. For these authors, earnings are considered a key measurement to evaluate stock prices. This is one of the reasons why revenue is an important measurement and since it is useful and easy to use.
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However, it is an absolute number and is therefore difficult to put into relation to other key measures. This is why it is still important to use it together with other financial measurements.
2.1.2 Ratios Along with profitability, it is also of interest for an investor to investigate liquidity and earnings structures of companies in order to gain a more wholesome overview. Since figures and absolute values in income statements and balance sheets on their own can be quite unhelpful, it is of interest to put them in perspective and context. One way of accomplishing that is to produce ratios from various numbers, in order to easier assess what is being presented in financial statements, ratios are also simplistic to obtain. A common indicator used is return on equity (ROE), which is expressed in a ratio that in turn can indicate a company’s future potentials as well as their current state. Investors are typically using a ratio such as this to make an assessment of companies (Alexander, D. and Nobes, C. 2004).
Ross, Westerfield and Jordan (2010) argue that financial ratios, calculated from common variables in financial statements, is associated with the following benefits; grading the performance of managers for the purpose of rewards, provide assessments of the future by supplying historical information to existing or new potential investors, provide information to creditors and suppliers, evaluating rivals competitive positions and evaluating acquisitions based on their financial performance. Other benefits provided by financial ratios are that they are often used as a mean to predict future firm performance. They can be used as inputs when performing empirical studies or to create models to forecast and predict firm failure or financial distress (Altman, 1968; Beaver, 1966).
2.1.3 Return on Equity Return on equity (ROE) is one such ratio that is often of interest to investigate. In previous well cited research it is common to use ROE as a way of measuring financial firm performance (Delen, Kuzey & Uyar, 2013). It relates earnings made by the company with the financing provided by shareholders, in the form of equity. It is obviously of interest for shareholders to assess the amount of net income that is returned as a percentage of the equity that they have provided.
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Dividend policy and its impact on firm valuation