Stock Distributions and the Market Reaction How can we tell what the motivation is behind stock dividends, stock

Stock Distributions and the Market Reaction How can we tell what the motivation is behind stock dividends, stock

splits, and reverse splits? We can’t. But we can get a general idea of how investors interpret these actions by looking at what happens to the firm’s share price when a corporation announces its decision to pay a stock dividend, split its stock, or reverse split. If the share price tends to go up when the announcement is made, the decision is probably good news; if the price goes down, the stock dividend is probably bad news. This is supported by evidence that indicates firms’ earnings tend to increase following stock splits and dividends. 11

The share price of companies announcing stock distributions and stock splits generally increase at the time of the announcement. 12 The most likely explanation is that this distribution is interpreted as good news—that management believes that the future prospects of the firm are favorable or that the share price is more attractive to investors.

The stock price of companies announcing a reverse stock split usu- ally decreases at the time of the announcement. 13 The most likely expla- nation for this decrease is that the firm is unable to increase the share price in any way other than through a reverse split. That is, the pros- pects of the firm are so bleak that this is the only way to increase the share price.

11 See, for example, Maureen McNichols and Ajay Dravid, “Stock Dividends, Stock Splits, and Signaling,” Journal of Finance (July 1990) pp. 857–879.

12 The stock price typically increases by 1 to 2% when the split or stock dividend is announced. When the stock dividend is distributed or the split is effected (on the

“ex” date), the share’s price typically declines according to the amount of the distri- bution. Suppose a firm announces a 2:1 split. Its share price may increase by 1 to 2% when this is announced, but when the shares are split, the share price will go down to approximately half of its pre-split value. See, for example, Mark Grinblatt, Ronald Masulis, and Sheridan Titman, “The Valuation Effects of Stock Splits and Stock Dividends,” Journal of Financial Economics (December 1984), pp. 461–490.

13 See, for example, David Peterson and Pamela Peterson, “A Further Evidence of Stock Distributions: The Case of Reverse Stock Splits,” Journal of Financial Re-

search (Fall 1992), pp. 189–206.

Common Stock

EXHIBIT 16.2 Dividends per Share and Dividend Payout for the Cooper Tire &

Rubber Company, 1980–2001

Source: Value Line Investment Survey Dividend Policy

A dividend policy is a firm’s decision about the payment of cash divi- dends to shareholders. Looking at the dividends per share and the divi- dend payout at a point in time doesn’t tell us much about the firm’s dividend policy. We generally need somewhat more information than one quarter’s or one year’s dividend. If we look at dividends over a longer period, we can begin to get a better picture of the firm’s dividend policy.

There are several basic ways of describing a firm’s dividend policy: ■ No dividends

■ Constant growth in dividends per share ■ Constant payout ratio ■ Low regular dividends with periodic extra dividends

The firms that typically do not pay dividends are those that are gener- ally viewed as younger, faster growing firms. For example, as of 2002, firms such as Microsoft Corporation (computer software), Amgen (bio- technology), and Amazon.com (internet retailer) had never paid dividends.

A common pattern of cash dividends tends to be the constant growth of dividends per share. As we see for Cooper Tire and Rubber in Exhibit

16.2, dividends per share grew at a constant rate after 1986 and until 1999.

FINANCING DECISIONS

EXHIBIT 16.3 Dividends per Share and Dividend Payout for the Sara Lee

Corporation, 1980–2001

Source: Value Line Investment Survey Another pattern is the constant payout ratio, as exhibited in Exhibit

16.3 by the Sara Lee Corporation. Sara Lee’s dividend payout is around 40% each year, with the most noticeable deviation occurring when it paid a special dividend in 1992. Many other companies in the food pro- cessing industry, such as Kellogg and Tootsie Roll Industries, pay divi- dends that are a relatively constant percentage of earnings.

Some companies display both a constant dividend payout and a con- stant growth in dividends. The dividends per share and dividend payout of General Electric common stock over the years 1980 through 2001 are graphed in Exhibit 16.4. Dividends per share grew steadily throughout much of this period. Looking at the dividend payout in this same figure, we see that it has been relatively constant throughout the period as well. This type of dividend pattern is characteristic of large, mature companies that have predictable earnings growth—the dividends growth tends to mimic the earnings growth, resulting in a constant payout.

U.S. corporations that pay dividends tend to pay either constant or increasing dividends per share. Dividends tend to be lower in industries that have many profitable opportunities to invest their earnings. But as

a company matures and finds fewer and fewer profitable investment opportunities, a greater portion of its earnings are paid out in dividends.

Common Stock

EXHIBIT 16.4 Dividends per Share and Dividend Payout for the General Electric

Corporation, 1980–2001

Source: Value Line Investment Survey Many firms are reluctant to cut dividends because the firm’s share

price usually falls when a dividend reduction is announced. 14 For exam- ple, the U.S. auto manufacturers cut dividends during the recession in the early 1990s, as illustrated in Exhibit 16.5 by General Motors (Panel

A) and Ford Motor Company (Panel B). As you can see in these graphs, as earnings per share declined the auto makers did not cut dividends until EPS were negative—and in the case of GM, not until it had experi- enced two consecutive loss years. But as earnings recovered in the mid- 1990s, dividends were increased. Firms tend to only raise their regular quarterly dividend when they are sure they can keep it up in the future. By giving a special or extra dividend, the firm is able to provide more cash to the shareholders without committing itself to paying an increased dividend each period into the future. Let’s look at an example. The fortunes of Longview Fibre, a timber growing and harvesting firm,

14 A number of studies have documented the fall in share price that accompanies a cut in dividends. See, for example, Richardson Pettit, “Dividends Announcements,

Security Performance, and Capital Market Efficiency,” Journal of Finance (Decem- ber 1972), pp. 86–96; and Joseph Aharony and Itzhak Swary, “Quarterly Dividend and Earnings Announcements and Stockholders’ Returns: An Empirical Analysis,” Journal of Finance (March 1980), pp. 1–12]. But just how much the share price falls depends on the reasons for the cut; see J. Randall Woolridge and Chinmoy Gosh, “Dividend Cuts: Do They Always Signal Bad News?” Midland Journal of Corporate Finance (Summer 1985), pp. 20–32.

FINANCING DECISIONS

vary depending on construction demand and timber cutting availability on public land, both of which are quite uncertain. Longview Fibre pays

a regular quarterly dividend around $0.10 a share, but also may pay special dividends that vary according to its earnings.

EXHIBIT 16.5 Dividends and Earnings per Share for General Motors and Ford

Motor Company, 1980–2001 Panel A: General Motors

Panel B: Ford Motor Company

Source: Value Line Investment Survey

Common Stock