Abstract
The purpose of our study is to explore what types of information content are conveyed by dividends on future earnings. We examine this issue by investigating the effect of dividends on the association between current year stock returns and future earnings (i.e. the future earnings response coefficient, FERC). Based on exploring the Taiwan market, our results reveal that taxable stock dividends enhance the FERC while nontaxable stock dividends do not, consistent with the tax-based signaling argument. We also find a positive relation between cash dividends and the FERC in firms with severe free cash flow problems, and this suggests that higher cash payouts mitigate manager over-investment so future earnings are more highly valued, consistent with the agency argument. Our main contributions are to specify what factors make dividends informative with regard to future earnings and the provision of evidence to support the tax-based signaling model.
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Notes
Prior empirical studies (Rankine and Stice 1997a, b) have found that, like cash dividends, stock dividends are also associated with firms’ earnings prospects, as argued by the “retained earnings hypothesis”. The reasoning for this is because managers voluntarily reducing distributable funds signal that such a reduction of retained earnings will not negatively impact the firm’s ability to make future cash distributions. This is puzzling because stock dividends themselves are seemingly cosmetic events given that they do not affect a firm’s cash flow.
In Taiwan, the tax rate for corporate income below NT$100,000 (about $3,000 US dollars) is 15%, and that above NT$100,000 is 25%. Since it is rare that listed firms make profits below NT$100,000, it is appropriate to conclude that corporate income is subject to essentially a single rate of 25%. Moreover, since January 1, 2010, the new individual income tax rates are 5, 12, 20, 30, 40 %, and the new corporate income tax rate is 17%.
Taiwanese firms pay dividends only once a year and thus the ex-dividend effects are larger. With regard to the magnitude of ex-dividend effects, Francis et al. (2012) provide evidence to show that in Taiwan the ex-dividend day pricing behaviors are significantly affected by dividend taxes.
The validity of the retained earnings hypothesis was questioned by Crawford et al. (2005), which show that the costs of reducing retained earnings are usually very small.
Signaling of cash dividends is costly for following reasons: First, dividends generate a shortfall in resources that requires raising capital, which in turn leads to financing transaction costs (e.g., EasterBrook 1984). Second, dividends lead investors to incur higher personal taxes relative to capital gains (e.g., John and Williams 1985). Third, cash dividend payout results in the suboptimal investment problem (e.g., Miller and Rock 1985).
Three years of data are used because Collins et al. (1994) reported that amounts further out in time add little explanatory power. Moreover, Lundholm and Myers (2002) showed that the full model (where each future earnings and future returns variable is included separately) and the reduced-form model where earnings and returns are aggregated over three years yield similar conclusions.
The use of the average of lagged dividends is because: (1) some studies (e.g., Lettau and Ludvigson 2005; Menzly et al. 2004) show the existence of a persistent component in the market’s dividend expectation, and this suggests that investors forecast dividends from a past average (2) there is evidence that the pattern of past dividend history conveys information about future dividend policy (e.g., DeAngelo et al. 1996). (3) due to the great flexibility of Taiwanese firms’ dividend payouts, the use of only the prior year’s dividend leads the UED t to be too volatile to produce reliable statistical inferences, and the use of averages smoothes the data and so alleviates this problem.
Dhaliwal et al. (2005) found that as shareholders’ tax rates increase, ERC decreases for firms with high levels of cash dividend yield. This supports the use of dividend level to capture the dividend tax effect.
Kallapur (1994) reported a positive link between cash dividend payout ratio and ERC, and this confirms the appropriateness of using dividend level to represent the magnitude of reduction in agency costs.
1995 is the first year the TEJ provided the fraction of shares held by the controlling shareholder, and 2007 is the last year that the earnings data of the subsequent 3 years were available at the time of this study.
For example, the cash-dividend-only sample requires firms to have ever declared cash dividends during the period between the current and the past 4 years, but to have had no taxable or nontaxable stock dividends and share repurchases in the same period. Likewise, taxable-stock-dividend-only and nontaxable-stock-dividend-only samples require similar selection criterion.
Supposing that firm A has never declared cash dividends in past years, and it changes to declare taxable stock dividend this year, the dividend change information reflected in stock returns can be attributed to either the initiation of the taxable stock dividend or the market’s disappointment that no cash dividend is declared, since past cash dividend history leads the market to expect the repetition of cash dividends. A four-year history of no other types of dividends reasonably eliminates the market’s expectation about these dividends, and so the empirical result can be attributed to the pure effect of a specific type of dividend.
The definition of industry is based on the classifications of the Taiwan Stock Exchange.
The coefficient on X t3·D t is positive for the CD case but negative for the TSD case. As a result, the incremental effect generated by cash payouts on the FERC is positive, consistent with the free cash flow argument.
To avoid potential collinearity that could confound our results, in following analyses we do not include these control variables.
Our definition of the controlling shareholders and the procedures in ferreting out chains of ownership closely follow Claessens et al. (2000) and La Porta et al. (1999), which are focused on ultimate ownership. The ultimate controlling shareholders are identified via a determination of each one’s share of voting and cash flow rights.
As illustrated in Nissim and Ziv (2001), consider a case where management predicts a permanent earnings increase of $4 starting year one. Assume further a timing error, so that $1 of earnings increase is realized in year three rather than in year two (that is, relative to year zero, earnings are higher by $4, $3, $5, and $4 in years one through four, respectively). When using a levels specification, earnings in year two are $1 below expectations and earnings in year three are $1 above expectations. On the other hand, when using a changes specification, the earnings change in year two is $1 below the (no-change) expectations; the earnings change in year three is $2 above expectations, and the earnings change in year four is $1 below expectations. That is, the impact of a timing error is more significant on the individual observations under a changes specification.
Although special dividends may be informative about future earnings like common dividends do, we do not analyze their effects, because unlike in the US, in Taiwan the issuances of special stocks are very rare, and the small sample size of special dividends makes it difficult to obtain any meaningful statistical results.
Because share repurchases are mostly employed by dividend-paying firms, restricting the sample for only repurchasing firms significantly reduces the sample size to only 68 observations. Unreported results indicate that, unlike the case for cash dividends, the frequency of share repurchasing shows no increasing trend over time.
We measure repurchases as net repurchases—share repurchases less the effect of share issuances. We follow the approach in Fama and French (2001) and Hanlon et al. (2007) by using the increase in common treasury stock if the firm uses the treasury stock method for repurchases. If the firm uses the ‘retirement’ method instead (which we infer from the fact that treasury stock is zero in the current and prior year), we measure repurchases as the difference between stock purchases and stock issuances from the statement of cash flows. If our computed net repurchase amount is negative, we reset it to zero.
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Data availability: Data used in this study are from public sources. A list of sample firms may be obtained on request.
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Kuo, NT. Dividend tax signaling and the pricing of future earnings: a case of taxable stock dividends. Rev Quant Finan Acc 40, 539–570 (2013). https://doi.org/10.1007/s11156-012-0287-y
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DOI: https://doi.org/10.1007/s11156-012-0287-y