19.4The Information Content of Dividend and Share Repurchase

Announcements

This section examines the information conveyed by dividend and share repurchase

announcements. As this chapter’s opening vignette illustrates, dividend changes can

lead to dramatic changes in stock prices.

Empirical Evidence on Stock Returns at the Time of Dividend Announcements

When firms announce dividend increases, their stock prices generally increase about 2

percent [see Aharony and Swary (1980)]. Announcements of the initiation of quarterly

dividend payouts by firms that previously paid no dividends generate even larger stock

price reactions [see Asquith and Mullins (1983), Healy and Palepu (1988), and

Michaely, Thaler, and Womack (1995)]. Moreover, stock prices generally experience

similar declines when firms announce dividend decreases or omissions, falling about

9.5 percent, on average, at the announcement of an omission [Healy and Palepu (1988)].

Result 19.4

Stock prices increase, on average, when firms increase dividends and decrease, on average,when they decrease dividends.

As a corporate executive, you might interpret a positive stock price reaction to an

announced dividend increase as evidence that investors consider the dividend increase

to be a good decision. This evidence, however, does not necessarily imply that dividend

increases improve the intrinsic value of firms. Financial decisions that convey favor-

able information to the market tend to increase stock prices even when the decisions

are bad for the firm’s future profitability. As shown below, dividend increases can

diminish intrinsic values, but still generate positive stock price responses because they

signal favorable information.

ADividend Signaling Model

Although finance researchers have proposed a number of signaling-based explanations

for the positive stock price response to dividend increases, we will describe only one

model.⁵This model, which we believe is the most intuitive, is based on an analysis of

what an all-equity-financed firm does with the operating cash flow produced by its

assets. The sources and uses of funds equation,

Operating cash flow investment expenditures change in equity dividends,

suggests that the cash flows produced by the assets of the firm (after taxes) either have

to be retained within the firm for investment expenditures (for example, for mainte-

nance of assets or expansion of assets) or be paid out to equity holders as either a share

repurchase or a dividend.

Information Observed by Investors.The following argument assumes that investors

cannot observe the operating cash flows of the firm, perhaps because managers can

manipulate the relevant accounting numbers. In addition, outside investors cannot

observe all the items that constitute the firm’s investment expenditures, such as equip-

ment maintenance and expenditures to update its customer database. We will assume,

⁵This discussion is based on Miller and Rock (1985).

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however, that investors know how much the firm shouldinvest to maximize shareholder

value. In addition, the investors do, of course, observe the dividends that they receive

as well as the amount of capital the firm either raises (for example, through an equity

offering) from the capital markets or retires (for example, by repurchasing shares).

The Information Content of a Dividend Change.The dividends and changes in out-

standing equity provide investors with information about the firm’s operating cash flows

as well as the level of investment expenditures. However, investors cannot decipher the

meaning of an unexpected change in dividends. For example, a dividend increase may

reflect the fact that the firm’s operating cash flow was higher than expected, which

would be good news, since this would suggest that the firm is more profitable than was

originally believed. On the other hand, the firm may have generated the cash for the

higher dividend by cutting back investment, which would be bad news because it

implies that the firm is sacrificing futureoperating cash flows to generate higher divi-

dends. To understand the information content of dividends we will first examine Exam-

ple 19.3, which considers the case where investors observe the level of investment

expenditures.

Example 19.3:The Information Content of Dividend Payouts

Analysts observe that Johnson Trucking, an all-equity firm, has not issued or repurchased

shares over the past year.They also have observed that Johnson has paid out $10 million

in dividends over the past year and they believe that the firm has invested $15 million of its

operating cash flow back into the business.From this information, what do the analysts infer

about the firm’s operating cash flows?

Answer:Since the level of equity financing has not changed, the level of dividends plus

investment must equal the operating cash flow.The analysts would thus infer that Johnson’s

operating cash flows were $25 million.

Example 19.3 suggests that an increase in dividends from $10 million to $15 mil-

lion would imply that Johnson Trucking’s operating cash flow increased from $25 mil-

lion to $30 million. This would be considered good news by shareholders and would

result in an increase in the firm’s stock price. Hence, a dividend change may convey

important information to shareholders even if managers are not explicitly trying to use

dividends as a signaling tool.

Dividend Signaling and Underinvestment.Amanager faced with the situation in

Example 19.3 would choose the optimal level of investment if he or she was interested

solely in maximizing the intrinsic value of the firm. However, as suggested above, a

manager who has an incentive to temporarily boost stock prices may want to cut back

on unobserved investment expenditures and use the proceeds to increase the distribu-

tion to shareholders. Hence, an incentive to convey favorable information to share-

holders will generally lead to observable payouts that are too high and unobservable

investment expenditures that are too low. Example 19.4 illustrates this possibility.

Example 19.4:Dividend Signaling and Underinvestment

Johnson Trucking is deciding whether to pay out $10 million (option 1), $15 million (option 2),

or $20 million (option 3) in dividends.As in Example 19.3, a $10 million dividend, which allows

investment of $15 million, will maximize the intrinsic value of the stock.Higher dividends, on

the other hand, will result in an immediate share price increase but, because of the cut in

investment expenditures, will reduce the firm’s intrinsic value.The following table provides the

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Strategy, Second Edition		Decisions

666Part VIncentives, Information, and Corporate Control

firm’s intrinsic values and current market values associated with the different dividend alterna-

tives.

Option 1	Option 2	Option 3
$10 million dividend	$15 million dividend	$20 million dividend
$15 million invested	$10 million invested	$5 million invested

Intrinsic value	$220 million	$210 million	$200 million
Current value	190 million	210 million	215 million

If managers want to maximize an equally weighted average of the firm’s current market value

and intrinsic value, what are they likely to decide?

Answer:The $15 million dividend (option 2) is the best option given the managers’pref-

erences.However, if they place significantly more weight on intrinsic value, they will prefer

the lower dividend;if they place more weight on current market value, they will prefer the

higher dividend.

Example 19.4 shows that Johnson Trucking’s market value and intrinsic values are

equal when the firm pays out $15 million in dividends (option 2), suggesting that the

market correctly inferred that the firm would invest only $10 million and correctly

priced the stock. In other words, the $15 million dividend signals the firm’s value

because analysts and investors correctly infer management’s incentive to increase the

firm’s current market value at the expense of its intrinsic value. If the firm had paid

out more dividends and invested less than analysts expected, there would have been a

deviation between the firm’s current stock price and its intrinsic value.

To understand this point, consider what would happen if analysts view managers

as having little incentive to increase the firm’s current stock price at the expense of

its intrinsic value when, in reality, their incentive to increase the stock price (per-

haps because of a takeover threat) was quite large. In such a case, a large dividend

would be incorrectly interpreted as evidence of increased operating cash flow when,

in reality, the cash for the dividend was generated by decreasing investment

expenditures.

Do Positive Stock Price Responses Imply That a Decision Creates Value?In

Example 19.4, the higher dividends (options 2 and 3) use funds that would have been

used more productively within the firm. However, analysts still view the higher divi-

dend payments as good news because they reveal that the firm has more cash—and

perhaps greater earnings potential—than the analysts had previously believed. In this

case, the stock price will react favorably to a dividend increase because of the infor-

mation it conveys, even though it is a bad decision. Similarly, stock prices may react

unfavorably to good decisions. If a firm is experiencing a cash shortfall, it may be in

the firm’s best interests to cut its dividend payout. However, the announcement of a

dividend cut would reveal the firm’s difficulties, so the market is likely to react nega-

tively to the announcement.

Result 19.5

An increased dividend implies, holding all else constant, higher cash flows and hence higherstock prices. By cutting investment expenditures on items that cannot be readily observedby analysts, firms can increase reported earnings and dividends, thereby increasing theircurrent stock prices. Amanager’s incentive to temporarily boost the firm’s stock price maythus lead the firm to pass up positive net present value investments.

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667

Result 19.5 indicates that share price increases that occur when firms announce

dividend increases do not imply that investors like the higher dividend payout. Although

the dividend increase conveys favorable information, it doesn’t necessarily create value

for shareholders. Hence, the observed stock price response to dividend increases is a

misguided rationale for increasing dividends.

Share Repurchases versus Dividends.Chapter 15 indicates that, in the absence of

taxes and transaction costs, dividends and share repurchases are essentially identical. A

share repurchase should also convey the same information as a dividend because, in

both cases, cash is distributed to shareholders, revealing to investors that the firm has

generated a sizable operating cash flow.

Indeed, Dann (1981) and Vermaelen (1981) documented impressive share price

responses to share repurchase announcements, suggesting that the repurchase alterna-

tive conveys the same favorable information to investors as a dividend payment. Dann

found that, on average, firms that repurchase shares with tender offers experience about

a 16 percent return on the announcement date. In his sample, the tender offers were

made at a premium that averaged about 22 percent above the stock price just before

the offer. The number of shares repurchased averaged about 15 percent of the out-

standing shares, taking the premium into account, which represented, on average, 19

percent of the outstanding equity of these firms.

Given the large number of shares repurchased in these tender offers, it is not sur-

prising that the stock price reaction to a share repurchase of this kind is much greater

than the price reaction to a dividend increase. When firms want to repurchase smaller

amounts of their stock (for example, 3 to 7 percent of their outstanding shares), they

usually buy the shares on the open market. The stock returns at the time of the

announcements of open market repurchase announcements are about 3 percent, which

is comparable to the returns from the initiation of a new dividend. However, as Example

19.5 illustrates, this is not the only explanation for why stock prices do not react as

much to open market repurchases as they do to tender offers.

Example 19.5:Share Price Response to an Open Market Repurchase

On September 12, 1988, Lotus Development Corporation announced that it would repur-

chase up to 15 percent of its outstanding shares in the open market.The stock reacted by

increasing from $17 to $18 per share.While the price increase was somewhat higher than

the average increase for an open market repurchase, the number of shares Lotus planned

to repurchase was substantially higher than the average.Indeed, the planned repurchase

was about as large as the typical tender offer repurchase in which stock prices generally

have a much greater reaction.Why didn’t Lotus’s stock price react more?

Answer:While various explanations can be offered about why Lotus’s stock price didn’t

react more favorably to the repurchase announcement, we emphasize the following:

1.	The announcement of an intention to repurchase a quantity of shares on the open market is not a firm commitment.Lotus could have repurchased fewer shares.

2.

In a tender offer, management offers to repurchase shares at a price substantiallyabove the prevailing stock price.This provides an additional signal of the stock’svalue since the firm would be substantially overpaying for its stock if the currentprice was not substantially below the stock’s intrinsic value.In open marketrepurchases, no premium is offered.

Whittakerand FPL: Simultaneous Dividend Cuts and Share Repurchases

For tax reasons, it makes sense to substitute a share repurchase for a dividend. In the-

ory, such a transaction should not convey information to investors if the amount of the

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668Part VIncentives, Information, and Corporate Control

repurchase is identical to the amount of the dividend cut. However, the market may view

the dividend cut positively if investors place a value upon receiving income in the form

of more lightly taxed capital gains. Alternatively, stock prices may react negatively if

the market views the share repurchase as a one-time event and the dividend cut as

permanent.

Unfortunately, there are few examples of firms substituting share repurchases for divi-

dend payments. However, Woolridge and Ghosh (1985) reported that on July 24, 1984,

Whittaker Corporation announced a cut in its cash dividend from $0.40 to $0.15 per share

and, at the same time, instigated a share repurchase plan. On the announcement, the share

price increased $0.125 to $18.625, suggesting that a dividend cut packaged with a share

repurchase is not necessarily bad news.

Similarly, Soter, Brigham, and Evanson (1996) reported that on May 9, 1994, Florida

Power and Light (FPL) announced a 32 percent dividend reduction along with its inten-

tion to repurchase up to 10 million shares over the next three years. In adopting this

change in dividend policy, the company noted the personal tax advantages of the substi-

tution of share repurchases for dividend payments. On the day of the announcement, the

company’s stock price fell from $31.88 to $27.50, a drop of almost 14 percent. However,

the drop in stock prices was quickly reversed; Soter, Brigham, and Evanson reported that

“as analysts digested the news and considered the reasons for the reduction, they con-

cluded that the action was not a signal of financial distress.” On May 31, FPL’s stock

closed at $32.17.

Result 19.6

It is unlikely that signaling considerations explain why firms pay dividends rather thanrepurchase shares.

Dividend Policy and Investment Incentives

The argument in the last subsection assumed that investors could correctly infer the

firm’s investment expenditures even though the investments are not directly observ-

able. This assumption requires that investors understand the investment opportuni-

ties of the firm as well as the degree of emphasis that managers place on maximiz-

ing the firm’s current share price versus maximizing the firm’s intrinsic value. If

investors know management’s incentives and understand the firm’s investment

opportunities, they can accurately infer how much the firm will invest. The only

unobservable factor in the all-equity firm’s sources and uses of funds equation would

then be operating cash flow, which can be inferred from the observed dividends and

changes in equity financing. (For firms with debt and equity financing, operating

cash flow could be inferred by additionally observing interest payments and changes

in debt financing.)

In reality, investors and analysts are usually unable to make accurate inferences

about a firm’s investment opportunities or how much managers want to invest. As a

result, the dividend choice conveys information about both the opportunities and incen-

tives to invest as well as the firm’s operating cash flows. This implies that a firm’s unan-

ticipated dividend cut could provide a mixed signal. Adividend cut could mean that the

firm was less profitable; alternatively, the cut could mean that the firm had good oppor-

tunities and planned on investing more than investors had previously anticipated.

Can Dividend Cuts Signal Improved Investment Opportunities?Adividend cut

that is interpreted to mean that the firm has increased investment expenditures can be

either good news or bad news, depending on whether investors believe that the firm

will be investing in positive or negative net present value projects. Woolridge and

Ghosh (1985) argued that if firms can effectively communicate to investors that an

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announced dividend cut is motivated by a desire to conserve cash to fund good invest-

ments, their stock prices will react favorably. To illustrate this point, the authors high-

lighted the April 11, 1975, announcement by Ford Motor Company of a cut in its quar-

terly dividend from $0.80 to $0.60 per share. This announcement, accompanied by a

statement by Henry Ford II that the cut would “conserve sufficient cash to finance prod-

ucts that can add to profitability in future years,” generated a 1.9 percent increase in

Ford’s stock price. However, as our chapter’s opening vignette on ITT’s dividend cut

indicates, investors are often skeptical about such statements. As a result, stock prices

usually fall when firms announce dividend cuts.

Dividend Cuts and the Incentive to Overinvest.Arguing that a dividend cut is made

to increase funds for investment will of course elicit a favorable price response only if

shareholders believe the firm will invest the money in positive net present value proj-

ects. As Chapter 18 noted, managers may overinvest because they prefer to see their

firms grow. Thus, a signal indicating that management plans to increase investment can

be considered both bad news and good news. As a result, stock price responses to div-

idend increases and decreases should depend on the investment opportunities available

to the firm. Investors would thus view a dividend increase more favorably when firms

have poorer investment opportunities.

Result 19.7

Adividend increase or decrease can provide information to investors about:

•	The firm’s cash flows.
•	Management’s investment intentions.

In the latter case, if investors believe that an increased level of investment associated with

a dividend cut is motivated by improved prospects, they will view the dividend cut favor-

ably. However, if investors believe that managers will make negative net present value

investments, they will interpret a dividend cut as bad news.

The findings in Lang and Litzenberger (1989) support the hypothesis that investors

view dividend cuts more favorably when firms have better investment prospects and

view dividend increases more favorably when investment prospects are poorer.⁶They

examined the stock price reactions to announced dividend increases and decreases for

stocks that differed according to the relation between their market values (MV) and their

book values (BV). Firms with market values that exceedtheir book values are believed

to have favorable investment opportunities while those with market values that are less

thantheir book values are believed to have unfavorable investment opportunities.

Lang and Litzenberger’s sample was divided into four groups.

1.Firms with MVBVwith dividend increases.

2.Firms with MV BVwith dividend decreases.

3.Firms with MV

BVwith dividend increases.

4.Firms with MV

BVwith dividend decreases.

As Exhibit 19.2 shows, a dividend increase created only a slight stock price

increase for firms believed to have favorable investment opportunities (that is,

MVBV). Likewise, a dividend decrease generated only a slight stock price decrease

⁶Litzenberger and Lang’s sample of daily returns consisted of 429 dividend change announcements

that met two criteria: (1) The absolute value of the percentage dividend change was greater than 10

percent; and (2) data on market and book values were available.

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670Part VIncentives, Information, and Corporate Control

EXHIBIT19.2Average Daily Returns on Dividend Announcement Days, 1979=84

		Difference in Absolute
Dividend	Dividend	Values for Increases
Increase	Decrease	and Decreases

MV BV	0.003a	0.003	0.000
MV BV	0.008a	0.027a	a
			0.019
Difference (Row 2 1)	0.005a	a	a
		0.024	0.019

^aStatistically different from zero.

Source: Lang and Litzenberger (1989).

for these firms. In contrast, dividend increases and decreases resulted in much larger

stock price responses for firms believed to have unfavorable investment opportunities

(that is, MV

BV). This evidence suggests that dividend changes are viewed as sig-

nals of the firm’s level of future investment.

Denis, Denis, and Sarin (1994) provided an alternative interpretation of the

observed differences in the stock price reaction of high and low MV/BVfirms to divi-

dend changes. They pointed out that high MV/BVfirms generally have lower dividend

yields and greater growth potential, which implies two things:

1.Increases in the dividends of high MV/BVfirms are less likely to be viewed

as a surprise.

2.High MV/BVfirms are likely to attract investors who are less interested in

dividends.

To understand the first point, recall from Chapter 11 that the Gordon Growth Model

version of the dividend discount equation can be rearranged to show that the cost of

capital is the sum of (1) the dividend yield and (2) the dividend growth rate. Hence,

holding the risk of the firm (and thus the cost of capital) constant, low dividend yields

imply high dividend growth rates and vice versa. The second point is an implication

of dividend clienteles, discussed in Chapter 15. Both of these factors suggest that high

MV/BVfirms will react less to dividend increases than low MV/BVfirms even in the

absence of the incentive problems discussed by Lang and Litzenberger.

Denis, Denis, and Sarin demonstrated that after accounting for differences in divi-

dend yields and the size of the dividend change, high and low MV/BVfirms react simi-

larly to dividend changes. In addition, they found that following dividend increases, stock

market analysts increase their earnings forecasts more for low MV/BVfirms than for high

MV/BVfirms. Based on this evidence, they concluded that stock prices respond to divi-

dend changes because of the information the announcements convey about the firm’s

future earnings. Their evidence does not support the idea that stock prices respond because

dividend changes provide information about the firms’future investment choices.

Dividends Attract Attention

An additional possibility is that a firm’s dividend increase or initiation results in a stock

price increase simply because it attracts attention to the firm. To understand why

investors generally view decisions that attract attention as good news, one must con-

sider the conditions under which the managers of a firm would put the firm under

greater scrutiny. If the firm is undervalued, increased scrutiny is likely to lead to a pos-

itive adjustment in the firm’s stock price, but if the firm is overvalued, the increased

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671

scrutiny is likely to lead to a negative adjustment in the firm’s stock price. Hence, the

incentive to attract attention is greatest for those firms that are the most undervalued,

which suggests that one might expect to see positive stock price reactions to any

announcements that attract considerable attention.

The positive stock price reactions observed at the time stock dividends and stock

splits are announced support the idea that stock prices respond to announcements of

managerial decisions that do no more than attract attention to the firm.⁷Unlike cash

dividends, stock dividends and splits affect neither the firm’s cash flows nor its invest-

ment alternatives. Yet, observed stock returns at the time of stock dividend and stock

split announcements are of approximately the same magnitude as the returns at the time

increases in cash dividends are announced.