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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 i

Master’s thesis within Business Administration, Finance Title: Dividend policy and its impact on firm valuation Authors: Adam Enebrand & Tobias Magnusson Advisor: Agostino Manduchi Co-advisor: Toni Duras Date: May 2018 Keywords: 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. ii

Table of contents Acknowledgements . ii Abstract. ii 1 2 3. Introduction & Background . 1 1.1 Introduction . 1 1.2 Problem Discussion. 1 1.3 Purpose . 3 1.4 Delimitations . 3 Theoretical framework . 4 2.1 Measurement of firm performance . 4 2.1.1 Earnings . 4 2.1.2 Ratios . 5 2.1.3 Return on Equity. 5 2.1.4 This study . 6 2.1.5 Limitations to ratios . 6 2.2 Dividends .7 2.2.1 Dividend relevance & irrelevance .7 2.2.2 Dividend & Payout Policy . 8 2.2.3 Dividend & stock price volatility . 9 2.3 Dividend policy & firm risk . 12 2.4 Asymmetric information & Signaling . 13 Methodology . 15 3.1 Approach . 15 3.2 Gathering of data . 16 3.3 Validity & Replicability and Methodology evaluation . 16 3.4 Data analysis and definitions . 17 3.5 Time period & Sample size . 17 3.6 Descriptive Statistic . 19 3.8 Research method. 21 3.8.1 Correlation . 21 iii

4. 5. 6. 3.8.2 Regression model . 22 3.9 Expected results & Hypothesis . 22 Empirical Results. 25 4.1 Descriptive Statistics . 25 4.2 Pearson Correlation . 25 4.3 Coefficients .27 Analysis . 30 5.1 Correlation & Multicollinearity . 30 5.2 Regression Output Analysis . 31 5.3 Theoretical discussion on empirical results . 35 Conclusion & Discussion . 37 6.1 Further Research & Implications . 38 6.2 Ethical issues & Societal Implications . 39 References . 40 Appendix . 45 iv

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 1

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. 2

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. 3

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. 4

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. 5

From a shareholders perspective, firm performance mainly is measured as the firm's ability to benefit owners, with this point of view ROE is the true bottom-line performance measurement. ROE is considered the measurement of how well the stockholders have fared during the measured time as it calculates the return on shareholders ownership, equity. ROE is therefore a common yet useful tool to measure how well the company is performing from the investors’ point of view (Ross, Westerfield and Jordan 2010). 2.1.4 This study In this study, focus will naturally be on financial performances such as profitability, growth and market value to measure how well the sample of selected firms perform. The two ratios chosen to measure firm performance is return on equity and gross profit margin. This suits the research well as the objective is to measure firm performance from the perspective of the investing market. 2.1.5 Limitations to ratios However, it should be noted that there are some limitations to using financial performance as a measure of firm performance. One example is a firm making investments and reorganizations in its structure, which can result in negative reported earnings during that period. Even though these investments are enabling great potential for the firm's future, the negative returns can make it appear as if though the firm does not perform well. This is typical for firms early in their life cycle, large initial investments leading to negative earnings that later turn to become positive (Damodaran, 1999). Another important aspect of financial ratios is that firms often try to adjust them to the industry averages, it is not uncommon, even if the firm do not actively adjust it, that the industry itself operates and affect the ratios. Therefore, the ratios do not just represent a firm's performance but could also contain information about the general market or industry which distorts the information that the ratio is providing. Firms in different industries can therefore provide different ratios as a response to what the rest of the industry looks like and not just their own financial condition (Lev, 1969). Shareholders do hold different interests and viewpoints on what is most important for a company, one example being whether they hold A-class shares or B-class shares (Alexander, D. and Nobes, C. 2004). In this study however, focus is on shares that are 6

generally available and interesting for the general public, A-class shares are in reality not commonly available for purchase for the average investor, mainly because of their powerful voting rights compared to B-class shares. This is the reason why they are excluded in this study from the sample that will be tested. 2.2 Dividends Dividend, or dividends, are the rewards that companies’ shareholders receive, in the form of cash, shares or other. The dividend is decided by a company’s board of directors and needs to be accepted by the shareholders. It is not a requirement to pay dividends to shareholders, however it is traditionally a popular method of rewarding shareholders as part of the company’s residual profit. Residual rewards refer to the funds that are left available after meeting other obligations such as paying creditors (The Economic Times, 2018). 2.2.1 Dividend relevance & irrelevance Developed by Gordon (1963) and Lintner (1962), the dividend relevance theory states that there is a direct relationship between the market value of a company and its dividend policy. One aspect and addition to this theory is the bird-in-the-hand argument which main point is that investors value current dividend over future dividend or capital gains (Gitman & Zutter, 2012). The argument is based on the notion that certain dividend today is more valuable than uncertain cash flows or returns in the future. As demonstrated by Lintner (1962) and Gordon (1963), the investors required rate of return decreased when dividend increased, cash dividend returns are more certain and therefore higher valued by the investors. Current dividend is seen as less risky, a sign of good financial firm health and as generating a positive effect on the stock price (Frankfurter, Wood & Wansley, 2003). On the dividend irrelevance side there is the capital structure irrelevance principle which was developed by Miller and Modigliani (1961). This theory states that a firm's value is determined by its earning power and its risk of investment. How the firm chooses to distribute its earnings, as dividend or reinvestments, is not relevant for the valuation of the firm. Another aspect here is that investors are indifferent whether their capital gain is derived from dividends or capital gain since if they are in need of cash they can sell some of their stocks. The return gained by the investor is therefore the same whether the stock 7

pay dividend or not, thus, the dividend policy is irrelevant for the stockholder and the possible returns (Gitman & Zutter, 2012). 2.2.2 Dividend & Payout Policy Determining whether or not to pay dividends, and to what extent, is affected by several factors that influence the policy regarding dividends that companies exhibit today. Exploring these factors and what drives the decisions companies make regarding paying dividends or to reinvest capital in to the company have been of interest for decades. Lintner (1956) identified a link between the stability of earnings and dividends, meaning that a projected increase or decrease of earnings would subsequently affect the level of dividend to be paid. Today, a link between the two still exists, however it has weakened while other factors have increased in significance. A company’s payout policy regarding dividends is in general highly conservative and fixed, meaning that managers are reluctant to cut dividends or even to try and change the policy in any manner altogether (Brav et. al, 2005). There are some key reasons for this that have remained fairly unchanged since Lintner (1956), the major reason is that cutting dividends is often associated, from the market’s viewpoint, with a company having financial difficulties, therefore a dividend cut would likely lead to the market assuming there is trouble and inevitably start generating uncertainty (Brav. et al, 2005). Policies regarding dividends have remained fairly unchanged, as mentioned, for decades mainly due to its inflexibility and strong symbolic value to important stakeholders. In contrast to this, it was not unsurprising to find that a majority of interviewees in the survey by Brav et. al, (2005) revealed that if managers were to choose a method of payout policy for the very first time, in a hypothetical scenario freed from constraints such as company tradition regarding paying dividends, they would prefer repurchasing shares rather than paying dividends (Brav et al., 2005). Noted here should be as well that opinions regarding the previously mentioned statement, concerning a hypothetical ‘clean slate’ scenario, differed depending on what policy the interviewee’s respective company currently has, which is logical since there will inevitably be a number of companies that believe that their current policy is what’s best suited for them, whether they pay dividends or not. 8

In the decades that has passed since Lintner, it can be concluded that a major finding, regarding dividend policy, its inflexibility and company’s conservative approach towards it, still holds in the 21st century. However, as mentioned, the policy of repurchasing company shares, as an alternative to paying dividends, from the marketplace has increased significantly in popularity since the mid 1900’s. This is not without its reason, for example, a company that currently faces few to no projects or investments that seem profitable based on standard present value calculations, are able to reduce levels of investment and instead increase payouts. The opposite is also true when faced with promising opportunities, to be able to decrease payments and instead increase capital that can be invested. Based on the findings in the survey, this is an important factor when faced with decisions regarding payout policies. To showcase how delicate it is to alter or reduce dividends, several managers in the survey admitted that their companies would be prepared to delay investments or even raise external capital simply to be able to maintain the established level of dividend per share in their respective company. Unsurprisingly, this can be hurtful to a company rather than helpful. Using repurchasing has other benefits beyond the aforementioned flexibility, since the number of shares outstanding is reduced, it can increase the level of earnings per share as well as raise market value on shares that are still outstanding. Commented [es1]: Källa? Commented [AE2R1]: Another key difference found in this survey is each payout policies priority with respect to operational and investment decisions (Brav. et al, 2005). Related to the mentioned conservatism regarding dividends, it is not unsurprising that managers view the level of dividend payouts as important as levels of investments. However in terms of repurchasing shares, managers argue that operational and investments actions are prioritized above that Commented [es3]: Egen åsikt? form of payout. 2.2.3 Dividend & stock price volatility The issue of financial reporting is something of high interest for both managers and investors. Managers are interested in financial reporting as the posts in it are closely related to their compensation and position. Investors are much interested in the figures presented as those are the foundation on which they base their valuation of the company (Dimitropoulos and Asteriou, 2018). Under the accrual basis of accounting, revenues are 9 Commented [es4]: Figures?

the summary measurement of firm performance. Over short periods, earnings are more strongly correlated to stock returns than realized cash flow, however, as measure period is increased, the cash flow is more related to stock price than the revenues themselves. The stock price of firms facing large changes in their working capital are also more related to reven

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

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