The View from NTU Professors: Does a dividend policy matter? 
17 Sep 2013 
By Jian Ming and Xu Ming

How does a company's dividend policy affect its valuation?

In a perfect market, it should not matter, but in the real world, the distribution of cash to investors does affect a firm's valuation. And the effect may depend on the market in which the company trades.

Classical finance theory states that in the absence of taxes, bankruptcy costs and information asymmetry, a firm's value is determined only by investment decisions that generate cash flows. The dividend policy is just a financial decision to distribute operating cash flows to investors, and should have no relevance to a firm's value.

But in the real world, dividends can affect it differently in different institutional environments. Companies, and indeed investors, need to be sensitive to this to rightly interpret the message delivered by the dividend distribution.

Spurring better management

A key deviation from the perfect market is the existence of agency costs. These arise from the separation of ownership and control, as is typical of many corporations around the globe. Shareholders own the firm but managers are the ones who make daily operational decisions.

As agents for shareholders, managers' interests are not necessarily aligned with those of the shareholders. Managers might invest in unprofitable projects for their own benefit - for instance, overpaying to acquire a target company so as to gain an impressive entry in their personal resume - or to generate other private benefits for themselves.

To address the agency problem, costs are incurred to monitor manager behaviour through financial disclosure, auditing and other mechanisms.

The dividend payout can help reduce agency costs. High dividend payments reduce the free cash flows available to managers, reducing the opportunity for them to invest in non-profitable projects.

Furthermore, with high dividend payouts, a firm is more likely to tap capital markets regularly to bolster internal funding, which will help keep managers on their toes.

In this way, managers can be better monitored and disciplined to make optimal investment decisions that improve the firm's performance and enhance shareholder value.

Therefore, we expect to observe a positive relationship between dividend payouts and the firm's value, as far as it helps address the agency problem.

Signalling insider information

Dividends can help address the problem of information asymmetry, where external investors have less access to information about the firm's prospects and performance than its managers and employees.

Dividends can be used by managers to signal their expectations of the firm's future performance, especially if mispriced by the market.

Higher payments often indicate stronger earnings potential, leading to positive coverage and "buy" recommendations by financial analysts.

Accordingly, many firms try to maintain a stable dividend policy. For example, when the Singapore Exchange's profits declined by one per cent for the year ended June 30, 2012, it retained a dividend payout of 27 cents per share.

This was to "keep faith with the proclaimed dividend policy", it said in its annual report. This signalling effect holds true, particularly for smaller firms where information asymmetry tends to be greater.

Market realities

In view of these market imperfections, high-dividend advocates believe that higher payouts are associated with better stock performance.

Is this true empirically?

More than half the firms listed on the Singapore bourse pay out cash dividends. According to our analysis of more than 700 firms listed between 1980 and last year, the average dividend yield for Singapore companies is around 3 per cent. Over the years, the average dividend yield has been stable except for a temporary dip during the Asian financial crisis in 1997.

Though some firms do not pay cash dividends, others such as Singapore Exchange, Venture Corp and Powermatics Data Systems adopt a high-dividend policy that pays out more than 80 per cent of net income.

Using Tobin's Q ratio and controlling for factors such as firm size, profitability, leverage, sales growth and percentage of intangible assets, we found that dividend change is significantly and positively associated with a firm's performance.

The greater the increase in dividend payments, the bigger the improvement in firm performance. Keeping all else constant, a one-percentage- point increase in dividend yield will on average raise a firm's Tobin's Q ratio by 0.005.

This translates into a $1.6 million increase in market value for an average-sized listed firm in Singapore. This positive association is consistent with both the agency cost theory and dividend signalling effect discussed earlier. Prior studies conducted in more developed economies show evidence of similar positive associations between firms' dividend policies and valuations.

However, the impact that dividends have on firms' valuations can be quite different elsewhere.

In China, we found that a dividend increase is associated with negative stock returns when it is accompanied by a large IPO price discount, a recent rights issue or great dividend variation.

This finding indicates that dividends in China are not used purely for signalling or distributing free cash flows. Instead, they may be used by controlling shareholders to engage in tunnelling, transferring firm assets and resources to themselves for personal gain.

This phenomenon might be due to the specific institutional setting and weak corporate governance, which make it easier for controlling shareholders to expropriate minority shareholders.

The different realities in Singapore and China demonstrate that in the real world, dividends can play different roles in affecting a firm's value in different institutional environments.

Managers should be careful about the possible effects when determining a firm's dividend policy; investors should take into consideration the company's institutional background when interpreting the message delivered by its dividend distributions.

The relationship between dividend payments and a firm's performance can be positive or negative, depending on market settings. An interesting follow-up to our studies would be to examine the messaging provided by the dividend policies of Chinese firms listed on the Singapore Exchange.

Associate Professor Jian Ming conducts research at Nanyang Business School on financial reporting, corporate finance and governance in emerging markets, especially China. Assistant Professor Xu Ming teaches corporate finance at Hong Kong Polytechnic University

Source: The Business Times, 17 September 2013