A Catering Theory of Dividends

A Catering Theory of Dividends Malcolm Baker Harvard Business School mbaker@hbs.edu Jeffrey Wurgler NYU Stern School of Business jwurgler@stern.nyu.edu October 19, 2022  We would like to thank Viral Acharya, Raj Aggarwal, Katharine Baker, Randy Cohen, Gene D'Avolio, Xavier Gabaix, Paul Gompers, Dirk Jenter, Kose John, John Long, Asis Martinez-Jerez, Colin Mayer, Holger Mueller, Eli Ofek, Lasse Pedersen, Gordon Phillips, Rick Ruback, David Scharfstein, Hersh Shefrin, Andrei Shleifer, Erik Stafford, Jeremy Stein, Ryan Taliaferro, Jerold Warner, and seminar participants at Harvard Business School, London Business School, LSE, MIT, Oxford, and the University of Rochester for helpful comments; John Long and Simon Wheatley for data; and Ryan Taliaferro for research assistance Baker gratefully acknowledges financial support from the Division of Research of the Harvard Business School A Catering Theory of Dividends Abstract We develop a theory in which the decision to pay dividends is driven by investor demand Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers To test this prediction, we construct four time series measures of investor demand for dividend payers: the difference in the average market-to-book ratios of current payers and nonpayers; the difference in the prices of Citizens Utilities cash and stock dividend share classes; the average announcement effect of recent dividend initiations; and the difference in future stock returns of payers and nonpayers By each of these measures, nonpayers initiate dividends when demand for payers is high By some measures, payers omit dividends when demand is low Further analysis indicates that these results are better explained by the catering theory than other theories of dividends I Introduction Miller and Modigliani (1961) prove that dividend policy is irrelevant to stock price in perfect and efficient capital markets In their setup, no rational investor has a preference between dividends and capital gains Arbitrage ensures that dividend policy does not affect stock prices Forty years later, perhaps the only assumption in this proof that has not been thoroughly scrutinized is market efficiency.1 In this paper, we present a theory of dividends that relaxes this assumption Our theory has three ingredients First, for a variety of psychological and institutional reasons, some investors have an uninformed, time varying demand for dividendpaying stocks Second, arbitrage fails to prevent this demand from occasionally driving apart the prices of stocks that and not pay dividends Third, managers cater to this demand, paying dividends when investors put a higher price on the shares of payers, and not paying when investors prefer nonpayers We call this a catering theory of dividends, and we formalize it in a simple theoretical model The catering theory is conceptually distinct from the traditional view of the relationship between dividend policy and investor demand, which emphasizes dividend irrelevance even when some investors have a rational preference for dividends For example, Black and Scholes (1974) write: “If a corporation could increase its share price by increasing (or decreasing) its payout ratio, then many corporations would so, which would saturate the demand for higher (or lower) dividend yields, and would bring about an equilibrium in which marginal changes in a corporation’s dividend policy would have no effect on the price of its stock” (p 2) This intuition for dividend irrelevance can also be found in corporate finance textbooks The catering theory and the Black and Scholes view differ on several important points One difference is that catering takes seriously the possibility that demand for dividends is Allen and Michaely (2002) provide a comprehensive survey of payout policy research affected by investor sentiment This adds a new and unexplored dimension to traditional sources of demand for dividends, such as taxes and transaction costs, which are the context of the Black and Scholes quote Another difference is that catering focuses on the demand for shares that pay dividends, and not necessarily the demand for an overall level of dividends For example, we discuss the possibility that certain investors categorize all dividend-paying shares together, and pay less attention to whether the yield on those shares is three or four percent But perhaps the most crucial difference is that catering takes a less extreme view on how fast managers or arbitrageurs eliminate an emerging dividend premium or discount According to Black and Scholes, managers compete so aggressively that a nontrivial dividend premium or discount never arises, and therefore dividend policy remains effectively irrelevant But this argument is compelling only if fluctuations in the demand for dividends are small relative to the capacity of firms to adjust dividends It is not obvious a priori that this is the case, particularly if demand is affected by sentiment The main prediction of the catering theory is that the propensity to pay dividends depends on a measurable dividend premium in stock prices To test this hypothesis, we construct four time series measures of the demand for dividend-paying shares The broadest one is what we simply call the dividend premium – the difference between the average market-to-book ratio of dividend payers and nonpayers The other measures are the difference in the prices of Citizens Utilities’ cash dividend and stock dividend share classes (between 1956 and 1989 CU had two classes of shares which differed in the form but not the level of their payouts); the average announcement effect of recent dividend initiations; and the difference in the future stock returns of payers and nonpayers Intuition suggests that the dividend premium, the CU dividend premium, and initiation effects would be positively related to investor demand for dividends In contrast, the difference in future returns of payers and nonpayers would be negatively related to any such demand – if demand for payers is so high that they are relatively overpriced, their future returns will be relatively low We then use these four measures of the demand for dividend-paying shares to explain time variation in dividend initiations and omissions The results on initiations are the strongest Each of the four demand measures is a significant predictor of the aggregate propensity to initiate dividends In terms of economic magnitude, the lagged dividend premium variable by itself explains a remarkable sixty percent of the annual variation in the propensity to initiate Another perspective is future stock returns When the propensity to initiate dividends increases by one standard deviation, returns on payers are lower than nonpayers by nine percentage points per year over the next three years Conversely, the propensity to omit dividends is high when the dividend premium variable is low, and when future returns on payers are high We consider several other explanations for these results, but conclude that they are best explained by catering Alternative explanations based on time varying firm characteristics such as investment opportunities or profitability, for example, not account for the results: The dividend premium variable helps to explain the residual propensity to initiate dividends that remains after controlling for changing firm characteristics, including investment opportunities, profits, and firm size Alternative explanations based on time varying contracting problems, such as agency costs or signaling theories, not address many aspects of the results, such as why dividend policy is related to the CU dividend premium and future returns We view the lack of a compelling alternative explanation, and the close connection between the predictions of catering and the patterns that we document, as evidence in favor of the catering explanation The next question is which aspect of investor demand creates a time varying dividend premium One possibility is sharp variations in tax clienteles or the transaction costs that determine the cost of homemade dividends Rational tax and transaction cost clienteles should be satisfied by changes in the overall level of dividends, not the number of shares that pay dividends But the dividend premium variable does not affect the overall dividend yield or payout ratio, just initiations and omissions Also, the relationship between initiations and omissions and the dividend premium is apparent in regressions that control explicitly for timeseries variation in taxes and transaction costs Another possibility is that investor sentiment creates a demand for dividend-paying shares Consistent with this hypothesis, we find a significant correlation between the dividend premium and the closed-end fund discount This suggests the possibility that unsophisticated investors view nonpayers as growth firms, and prefer them to payers when they are optimistic about growth prospects in general In summary, we develop and find some initial empirical support for a theory of dividends that relaxes the market efficiency assumption of the Miller and Modigliani proof The theory thus adds to the collection of dividend theories that relax other assumptions of the proof It also adds to the growing literature on behavioral corporate finance Shefrin and Statman (1984) develop a theory of investor demand for dividends that emphasizes self-control problems The catering theory is closer in spirit to recent research that views corporate decisions as rational responses to mispricing For example, Baker and Wurgler (2000, 2002) and Baker, Greenwood, and Wurgler (2002) view capital structure and security issuance decisions as rational responses to mispricing, or to perceptions of mispricing Shleifer and Vishny (2002) develop a theory of mergers based on rational responses to mispricing Morck, Shleifer, and Vishny (1990), Stein (1996), Baker, Stein, and Wurgler (2001), and Polk and Sapienza (2001) study rational corporate investment in inefficient capital markets The survey results of Graham and Harvey (2001) and the insider trading patterns in Jenter (2001) provide further evidence for the theme that managers react to perceived mispricing Section II develops the theory and outlines a simple model Section III presents the main empirical results Section IV considers potential alternative explanations Section V concludes and highlights directions for future research II A catering theory of dividends The theory has three ingredients First, there is a time varying, uninformed demand for the shares of firms that pay cash dividends This demand could reflect institutional changes, psychological influences, or both Second, limited arbitrage means that this demand affects prices Third, managers rationally cater in response They tend to pay dividends if investors put a higher price on payers, and not pay if investors favor nonpayers A simple model illustrates some subtleties of catering as a managerial policy A Uninformed demand for dividends We posit that sometimes investors generally prefer stocks that pay cash dividends, and sometimes they generally prefer nonpayers A useful framework for thinking about this hypothesis is categorization Categorization refers to the cognitive process of grouping objects into discrete categories such as “birds” or “chairs.” This allows related objects to be considered together, in terms of a small set of common features that define category membership, rather than as individual objects, each with its own long list of identifying attributes Categorization thus speeds up communication and inference Rosch (1978) provides a detailed discussion of theory and evidence on categorization In standard investment theory, of course, investors conspicuously not categorize They view each security as a list of abstract statistics, such as mean, variance, and covariance But in reality, as Barberis and Shleifer (2002) point out, investors typically categorize securities into groups such as “small stocks,” “value stocks,” “tech stocks,” “old-economy stocks,” “junk bonds,” “utilities,” and so forth For many investors, these labels appear to capture all they want to know, or have the ability to process, about the securities within the category There are several reasons to expect that unsophisticated investors and certain institutions categorize “dividend payers” directly or use dividend policy to classify stocks as “old economy,” for example Whether a stock pays dividends is a salient characteristic, perhaps even more so than industry, size, or index membership One reason why dividends are salient is a pervasive belief that dividend-paying stocks are less risky This notion is common in the popular financial press, and was once common in the academic literature Naïve investors, such as retirees and those who hold dividend-paying stocks for “income” despite the tax penalty, are especially likely to fall prey to this bird-in-the-hand argument For them, the quarterly dividend check is much more salient than daily gyrations in the stock price, with the result that dividends and capital gains are in separate mental accounts To the extent that the risk tolerance of bird-in-the-hand investors changes over time, their preferences for payers and nonpayers will change over time This is one mechanism by which unsophisticated investors may display a time varying preference for dividend payers Another way dividend policy becomes salient is if some investors use it to infer managers’ investment plans For example, it is reasonable to expect that investors interpret Hyman (1988) describes investor reaction to Consolidated Edison’s 1974 dividend omission “[It] hit the industry with the impact of a wrecking ball It smashed the keystone of faith for investment in utilities: that the dividend is safe and will be paid.” (p 109) Graham and Dodd (1951) and Gordon (1959) are recognized for this idea Miller and Modigliani (1961) cite a number of other papers of this vintage that make the same argument nonpayment, controlling for profitability, as evidence that the firm thinks it has excellent investment opportunities Conversely, payment may be taken as evidence that opportunities are weak These inferences create another channel though which payers and nonpayers become distinct categories, and they lead to a second mechanism that generates a time varying uninformed demand for payers That is, when investors’ perceptions of overall growth opportunities are high, they prefer nonpayers, and vice-versa Note that time variation in the demand for payers here is driven by perceptions of growth opportunities, not risk tolerance as in the mechanism outlined above One popular model (Shiller (1984, 2000)) that combines both of these effects is that steady dividends mean “old-economy.” Old-economy stocks are viewed as safer but also as having less potential than the “new-economy” stocks which plow back everything to finance growth Black and Scholes (1974) and Allen, Bernardo, and Welch (2000), among others, suggest that institutional frictions also lead to the rational categorization of dividend payers Taxes and the transaction costs of making homemade dividends are obvious examples of such frictions Time variation in these frictions can then induce time varying preferences for payers Many endowed institutions are restricted to spending from income, for example, an obvious reason to categorize payers In terms of time variation, the 1970s witnessed a number of potentially significant events The 1974 ERISA may have increased the attractiveness of payers to pension funds (Del Guercio (1996) and Brav and Heaton (1998)) The 1975 advent of negotiated commissions reduced the cost of creating homemade dividends and therefore may have increased the demand for nonpayers The Nixon dividend controls, which limited dividend growth between 1971 and 1974, may have elevated the “grandfathered” shares that had already established a high level of dividends And of course changes in the tax treatment of dividends, such as that generated by the 1986 Tax Reform Act, may change the demand for dividend payers without any link to their pretax fundamentals Given that categorization occurs, time varying demand between categories could also arise from what Mullainathan (2002) calls categorical inference Investors using categorical inference may, for example, overestimate the impact of news about a particular dividend payer for other dividend payers, and underestimate its impact for nonpayers This suggests that even without any explicit preference for cash dividends, the fact that categories have already been built around dividends could potentially lead to variation in demand between payers and nonpayers In summary, there are several reasons why some investors may view dividend payers as special Some of them reflect investor psychology, while others reflect institutional constraints or frictions The discussion also identifies psychological and institutional mechanisms that can lead to a time varying preference for dividend payers.4 B Limited arbitrage In the perfect and efficient markets of Miller and Modigliani (1961), uninformed demand for dividends would not affect stock prices Arbitrage would prevent it Arbitrageurs could short the firm with a preferred dividend policy and go long a correctly priced “perfect substitute” – a firm with the same investment policy but a different dividend policy In perfect and efficient markets, only investment policy affects stock prices, so an arbitrage follows by making homemade dividends on the long firm to match the dividends declared by the short firm In the absence of further frictions, this position delivers an up-front gain and can be risklessly held Building on ideas in Thaler and Shefrin (1981), Shefrin and Statman (1984) propose that some investors prefer dividend-paying stocks (over homemade dividends) because of self-control problems If self-control problems vary over the business cycle, for example, they could also generate time varying sentiment for dividends Neal, Robert, and Simon M Wheatley, 1998, Do measures of investor sentiment predict returns?, Journal of Financial and Quantitative Analysis 33, 523-547 Newey, Whitney K, and Kenneth D West, 1987, A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix, Econometrica 55, 703-708 Ofek, Eli, and Matthew Richardson, 2001, DotCom mania: The rise and fall of internet stock prices, NYU working paper Peterson, Pamela, David Peterson, and James Ang, 1985, Direct evidence on the marginal rate of taxation on dividend income, Journal of Financial Economics 14, 267-82 Polk, Christopher, and Paola Sapienza, 2001, The real effects of investor sentiment, Northwestern University working paper Pontiff, Jeffrey, 1996, Costly arbitrage: Evidence from closed-end funds, Quarterly Journal of Economics 111, 1135-1152 Pontiff, Jeffrey, and Michael J Schill, 2001, Long-run seasoned equity offering returns: Data snooping, model misspecification, or mispricing? A costly arbitrage approach, University of Washington working paper Poterba, James M., 1986, The market valuation of cash dividends: The Citizens Utilities case reconsidered, Journal of Financial Economics 15, 395-405 Poterba, James M., 1987, Tax policy and corporate saving, Brookings Papers on Economic Activity 2, 455-503 Rau, P Raghavendra, Ajay Patel, Igor Osobov, Ajay Korana, and Michael J Cooper, 2001, The game of the name: Value changes accompanying dot.com additions and deletions, Purdue University working paper Rosch, Eleanor, 1978, Principles of categorization, in Eleanor Rosch and Barbara B Lloyd, eds.: Cognition and Categorization (Lawrence Erlbaum Associates, Hillsdale, NJ) Shefrin, Hersh M., and Meir Statman, 1984, Explaining investor preference for cash dividends, Journal of Financial Economics 13, 253-282 Shiller, Robert J., 1984, Stock prices and social dynamics, Brookings Papers on Economic Activity 2, 457-498 Shiller, Robert J., 1989, Market Volatility, (MIT Press, Cambridge, MA) Shiller, Robert J., 2000, Irrational Exuberance, (Princeton University Press, Princeton, NJ) Shleifer, Andrei, and Robert W Vishny, 1992, Equilibrium short horizons of investors and firms, American Economic Review Papers and Proceedings 80, 148-153 Shleifer, Andrei, and Robert W Vishny, 1997, The limits of arbitrage, Journal of Finance 52, 3555 45 Shleifer, Andrei, and Robert W Vishny, 2002, Stock market driven acquisitions, Harvard University working paper Stambaugh, Robert F., 1999, Predictive regressions, Journal of Financial Economics 54, 375421 Stein, Jeremy C., 1989, Efficient capital markets, inefficient firms: A model of myopic corporate behavior, Quarterly Journal of Economics 104, 655-669 Stein, Jeremy C., 1996, Rational capital budgeting in an irrational world, Journal of Business 69, 429-455 Thaler, Richard, and Hersh M Shefrin, 1981, An economic theory of self-control, Journal of Political Economy 89, 392-406 Vuolteenaho, Tuomo, 2000, Understanding the aggregate book-to-market ratio and its implications to current equity-premium expectations, Harvard University working paper Watts, Ross, 1973, The information content of dividends, Journal of Business 46, 191-211 Wurgler, Jeffrey, and Katia Zhuravskaya, 2002, Does arbitrage flatten demand curves for stocks?, Journal of Business (forthcoming) Zweig, Martin E., 1973, An investor expectations stock price predictive model using closed-end fund premiums, Journal of Finance 28, 67-87 46 Figure Valuation of dividend payers and nonpayers and the dividend premium, 1962-2000 The average market-to-book ratio for dividend payers and nonpayers and the dividend premium (the log difference in average market-to-book ratios) A firm is defined as a dividend payer at time t if it has positive dividends per share by the ex date (Item 26) The market-to-book ratio is the ratio of the market value of the firm to its book value Market value is equal to market equity at calendar year end (Item 24 times Item 25) plus book debt (Item minus book equity) Book equity is defined as stockholders’ equity (generally Item 216, with exceptions as noted in the text) minus preferred stock (generally Item 10, with exceptions as noted in the text) plus deferred taxes and investment tax credits (Item 35) and post retirement assets (Item 330) The average market-to-book ratios are constructed by valueweighting (by book value) across dividend payers and nonpayers and are plotted in Panel A Panel B plots the log difference between the market-to-book ratio of payers and nonpayers Panel A Average market-to-book ratio of dividend payers (dashed line) and nonpayers (solid line) 3.50 3.00 2.50 2.00 1.50 1.00 0.50 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1977 1978 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 1962 0.00 Panel B The dividend premium % 40 30 20 10 -10 -20 -30 -40 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 1962 Figure The dividend premium and the propensity to initiate dividends, 1962-2000 The log difference in the market-to-book ratio of dividend payers and nonpayers and one-year-ahead dividend initiations A firm is defined as a dividend payer at time t if it has positive dividends per share by the ex date (Item 26) The market-to-book ratio is the ratio of the market value of the firm to its book value Market value is equal to market equity at calendar year end (Item 24 times Item 25) plus book debt (Item minus book equity) Book equity is defined as stockholders’ equity (generally Item 216, with exceptions as noted in the text) minus preferred stock (generally Item 10, with exceptions as noted in the text) plus deferred taxes and investment tax credits (Item 35) and post retirement assets (Item 330) The market-to-book ratio is value-weighted (by book value) across dividend payers and nonpayers The difference between the logs of these two ratios (dashed line – left axis) is plotted against the propensity to initiate dividends in t+1 (the number of new dividend payers at time t+1 among surviving nonpayers from t) (solid line – right axis) 40 18 16 30 14 20 12 10 2000 19 19 19 19 19 19 8 19 19 19 19 19 19 19 19 19 19 19 6 19 19 10 -10 -20 -30 -40 Figure The dividend premium and the closed-end fund discount The log difference in the market-to-book ratio of dividend payers and nonpayers and the closed-end fund discount The value-weighted closed-end fund discount uses data on net asset values and market prices for general equity and convertible funds from Simon and Wheatley (1997) for 1962 to 1993, from CDA/Wiesenberger for 1994 to 1998, and from the Wall Street Journal for 1999 to 2000 A firm is defined as a dividend payer at time t if it has positive dividends per share by the ex date (Item 26) The market-to-book ratio is the ratio of the market value of the firm to its book value Market value is equal to market equity at calendar year end (Item 24 times Item 25) plus book debt (Item minus book equity) Book equity is defined as stockholders’ equity (generally Item 216, with exceptions as noted in the text) minus preferred stock (generally Item 10, with exceptions noted in the text) plus deferred taxes and investment tax credits (Item 35) and post retirement assets (Item 330) The market-to-book ratio is value-weighted (by book value) across dividend payers and nonpayers The difference between the logs of these two ratios (dashed line – left axis) is plotted against the contemporaneous closed end fund discount (solid line – right axis) 40 30 25 30 20 20 15 10 2000 19 19 19 19 19 19 8 19 19 19 19 19 19 19 19 19 19 19 6 19 19 10 -10 -20 -5 -30 -40 -10 -15 Table Summary measures of dividend policy, 1962-2000 Dividend payers, nonpayers, and the propensity to pay A firm is defined as a dividend payer at time t if it has positive dividends per share by the ex date (Item 26) A firm is defined as a new dividend payer at time t if it has positive dividends per share by the ex date at time t and zero dividends per share by the ex date at time t-1 A firm is defined as an old payer at time t if it has positive dividends per share by the ex date at time t and positive dividends per share by the ex date at time t-1 A firm is defined as a new list payer if it has positive dividends per share by the ex date at time t and is not in the sample at time t-1 A firm is defined as a nonpayer at time t if it does not have positive dividends per share by the ex date New nonpayers are firms who were payers at time t-1 but not at t Old nonpayers a firms who were nonpayers in both t-1 and t New list nonpayers are nonpayers at t who were not in the sample at t-1 The propensity to initiate dividends PTP New expresses payers as a percentage of surviving nonpayers from t-1 The propensity to continue paying dividends PTP Old expresses payers as a percentage of surviving payers from t-1 The propensity to list as a payer PTP List expresses payers as a percentage of new lists at t Payers Year 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Mean SD Nonpayers Propensity to pay (PTP) % Total New Old List Total New Old List New Old List 529 585 681 821 888 954 1,018 1,048 1,030 1,281 1,627 1,719 1,802 1,878 1,944 1,956 1,925 1,854 1,738 1,631 1,523 1,450 1,378 1,270 1,214 1,185 1,162 1,148 1,128 1,140 1,148 1,163 1,165 1,153 1,101 1,042 975 871 1,247 402 21 17 24 16 13 11 14 10 20 43 97 130 118 167 146 96 64 58 48 37 40 59 57 39 49 92 83 61 51 62 60 61 66 44 38 37 27 30 55 38 467 519 565 659 793 849 908 946 951 953 1,221 1,535 1,593 1,670 1,756 1,747 1,761 1,735 1,634 1,545 1,434 1,346 1,282 1,176 1,112 1,057 1,041 1,053 1,052 1,036 1,043 1,059 1,068 1,061 1,027 978 916 824 1,119 379 41 49 92 146 82 94 96 92 59 285 309 54 91 41 42 113 100 61 56 49 49 45 39 55 53 36 38 34 25 42 45 43 31 48 36 27 32 17 73 63 149 154 167 238 288 361 438 554 639 862 1,127 1,044 1,052 941 821 856 1,046 1,137 1,417 1,621 1,929 2,111 2,133 2,373 2,651 2,563 2,432 2,403 2,497 2,674 3,049 3,286 3,416 3,774 3,784 3,501 3,320 3,042 1,693 1,180 14 19 16 54 75 52 22 44 65 58 30 53 45 68 90 78 100 50 42 73 61 50 59 49 59 56 55 55 31 40 52 35 31 50 45 24 123 121 119 145 216 263 330 406 502 568 719 908 853 813 721 651 708 882 962 1,210 1,380 1,605 1,698 1,744 1,971 2,123 2,036 2,011 2,015 2,085 2,342 2,634 2,772 2,924 3,110 2,997 2,806 2,587 1,336 974 18 27 45 88 58 79 92 94 62 242 386 92 134 70 70 152 293 187 365 333 449 456 393 556 619 390 337 343 423 533 652 597 613 810 622 469 483 405 312 219 14.6 12.3 16.8 9.9 5.7 4.0 4.1 2.4 3.8 7.0 11.9 12.5 12.2 17.0 16.8 12.9 8.3 6.2 4.8 3.0 2.8 3.5 3.2 2.2 2.4 4.2 3.9 2.9 2.5 2.9 2.5 2.3 2.3 1.5 1.2 1.2 1.0 1.1 6.1 5.0 98.3 98.9 99.5 99.2 98.3 97.8 98.3 94.6 92.7 94.8 98.2 97.2 96.1 96.6 98.3 97.1 97.5 96.2 94.8 95.2 93.5 96.4 96.8 94.2 94.8 95.5 94.6 95.6 94.7 94.9 95.0 95.1 97.2 96.4 95.2 96.5 96.7 94.3 96.2 1.7 69.5 64.5 67.2 62.4 58.6 54.3 51.1 49.5 48.8 54.1 44.5 37.0 40.4 36.9 37.5 42.6 25.4 24.6 13.3 12.8 9.8 9.0 9.0 9.0 7.9 8.5 10.1 9.0 5.6 7.3 6.5 6.7 4.8 5.6 5.5 5.4 6.2 4.0 27.0 22.5 Table The dividend premium, 1962-2000 The market valuations of dividend payers and nonpayers A firm is defined as a dividend payer at time t if it has positive dividends per share by the ex date (Item 26) The market-to-book ratio is the ratio of the market value of the firm to its book value Market value is equal to market equity at calendar year end (Item 24 times Item 25) plus book debt (Item minus book equity) Book equity is defined as stockholders’ equity (generally Item 216, with exceptions as noted in the text) minus preferred stock (generally Item 10, with exceptions as noted in the text) plus deferred taxes and investment tax credits (Item 35) and post retirement assets (Item 330) The market-to-book ratio is equal-weighed (EW) and value-weighted by book value (VW) across dividend payers and nonpayers These ratios are calculated for the entire sample and for new lists A firm is defined as a new list if it is not in the sample at time t-1 The dividend premium PD-ND is the difference between the logs of the dividend payers and nonpayers market-tobook ratios Payers Total Year 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Mean EW M/B 1.50 1.58 1.68 1.76 1.52 1.87 1.99 1.60 1.43 1.64 1.62 1.19 0.93 1.03 1.08 1.06 1.08 1.14 1.25 1.15 1.23 1.41 1.31 1.43 1.53 1.47 1.48 1.54 1.39 1.59 1.63 1.68 1.55 1.64 1.69 1.86 1.79 1.68 1.65 1.48 List VW M/B 1.55 1.70 1.79 1.80 1.50 1.66 1.69 1.47 1.41 1.50 1.59 1.32 1.01 1.12 1.16 1.05 1.03 1.04 1.12 1.01 1.05 1.14 1.13 1.21 1.29 1.28 1.24 1.32 1.26 1.40 1.41 1.43 1.40 1.55 1.67 1.89 2.12 2.05 1.90 1.42 Dividend Premium (PD-ND) Nonpayers EW M/B 1.50 1.71 2.09 1.60 1.35 2.34 2.35 1.84 1.51 2.14 1.70 1.27 1.11 0.90 1.37 1.24 1.13 1.33 1.87 1.46 1.37 1.76 1.72 1.64 1.93 1.85 1.47 1.51 1.79 1.31 2.03 1.74 1.48 1.83 2.05 1.83 1.98 1.40 2.18 1.66 Total VW M/B 1.36 1.49 2.10 1.47 1.20 1.83 2.89 1.67 1.67 2.01 1.74 1.27 0.91 0.86 1.11 1.23 1.48 0.92 1.20 1.11 1.32 1.21 1.47 0.91 1.44 1.53 1.38 1.25 1.80 1.24 1.34 1.38 1.47 1.86 1.88 1.52 2.21 1.34 1.48 1.48 EW M/B 1.19 1.30 1.37 1.61 1.52 2.36 2.73 1.78 1.38 1.48 1.48 1.16 0.91 1.05 1.13 1.18 1.34 1.75 2.33 1.87 2.03 2.31 1.79 2.00 2.27 2.03 1.94 1.97 1.76 2.32 2.23 2.33 2.04 2.57 2.41 2.35 2.22 3.54 2.26 1.88 List VW M/B 1.10 1.23 1.26 1.43 1.43 1.98 2.03 1.52 1.20 1.25 1.22 1.02 0.89 0.95 0.99 1.00 1.08 1.19 1.40 1.29 1.24 1.48 1.28 1.36 1.39 1.38 1.35 1.44 1.27 1.47 1.49 1.60 1.51 1.80 1.84 1.99 2.09 2.86 2.33 1.45 EW M/B 1.25 1.88 1.46 1.74 1.55 3.42 3.32 1.90 1.77 2.23 1.84 1.46 1.08 1.40 1.69 1.32 1.63 2.71 3.86 2.69 3.14 3.18 2.29 3.07 3.61 2.83 3.04 3.08 2.27 3.45 2.82 2.96 2.59 3.64 3.03 3.02 3.57 7.97 3.03 2.64 Total VW M/B 1.12 1.71 1.41 1.52 1.47 2.65 2.45 1.70 1.64 1.90 1.47 1.27 0.99 1.05 1.06 1.09 1.24 1.61 1.69 1.88 2.05 1.85 1.41 1.82 1.74 1.55 1.48 1.61 1.19 1.50 1.72 1.82 1.82 2.02 2.09 2.22 2.17 3.41 1.69 1.69 EW 22.9 19.4 20.1 8.8 0.2 -23.5 -31.7 -10.4 3.1 10.3 9.4 3.2 2.0 -2.5 -4.2 -10.7 -22.1 -43.2 -61.9 -48.2 -50.1 -49.3 -31.7 -33.2 -39.7 -32.4 -27.2 -24.9 -23.5 -37.8 -31.1 -33.1 -27.6 -44.7 -35.5 -22.9 -21.8 -74.9 -31.5 -21.1 List VW 34.9 32.9 35.6 22.6 5.4 -17.2 -18.8 -3.8 16.0 18.2 26.6 25.9 13.2 15.6 15.6 4.6 -5.0 -14.3 -22.1 -24.9 -16.9 -26.2 -12.5 -11.0 -7.3 -7.8 -7.8 -8.7 -1.0 -4.6 -5.3 -11.5 -7.5 -15.1 -9.4 -4.8 1.4 -33.2 -20.6 -0.7 EW 18.6 -9.7 35.6 -8.5 -14.3 -38.0 -34.4 -3.4 -15.6 -4.0 -8.3 -14.1 3.1 -44.6 -20.5 -6.3 -36.5 -71.6 -72.5 -61.2 -82.6 -59.1 -28.6 -62.8 -63.0 -42.4 -72.8 -71.2 -23.5 -96.8 -32.8 -53.2 -55.7 -68.6 -39.0 -50.1 -59.0 -173.6 -33.1 -40.4 VW 19.8 -13.8 40.0 -3.1 -20.2 -36.8 16.8 -2.1 1.4 5.6 17.0 -0.7 -7.6 -19.9 4.2 12.0 17.6 -55.6 -34.2 -53.3 -44.1 -42.9 3.5 -68.6 -18.5 -1.4 -7.1 -25.3 41.4 -19.4 -25.1 -27.4 -21.7 -8.0 -10.7 -38.0 1.9 -93.0 -13.3 -13.6 SD 0.26 0.30 0.35 0.40 0.55 0.41 1.19 0.47 23.7 18.0 36.7 27.8 Table The Citizens Utilities dividend premium and market reactions to dividend initiations, 1962-2000 The Citizens Utilities (CU) price ratio is the log of the ratio of the annual average cash dividend class share price to the annual average stock dividend class share price The 1962 through 1972 data are from Long (1978) and the 1973 through 1989 data are from CRSP A firm is defined as a new dividend payer at time t if it has positive dividends per share by the ex date (Item 26) at time t and zero dividends per share by the ex date at time t-1 We take the first dividend declaration date (DCLRDT) from CRSP in the twelve month period prior to the fiscal year ending in t We calculate the sum of the differences between the firm return (RET) and the CRSP value-weighted market return (VWRETD) for a three-day window [-1, +1] around the declaration date The announcement effect A scales this return by the standard deviation of the excess returns between 120 calendar days and five trading days before the declaration date The test statistic from Campbell, Lo, and Mackinlay (1997, equation 4.4.24) is shown in braces and tests the null hypothesis of zero average price reaction in year t CU Dividend Premium Initiation Announcement Effect Year 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Mean SD PCU 0.96 0.98 1.00 1.00 1.00 0.95 0.97 0.97 1.00 0.96 0.93 0.96 0.99 0.96 0.93 0.91 0.90 0.89 0.87 0.92 0.93 0.81 0.89 0.93 1.00 0.92 0.86 0.84 0.94 0.05 N 17 21 21 10 10 10 19 39 112 94 128 128 114 68 43 35 33 22 25 47 34 31 50 65 50 46 31 46 42 51 44 18 20 19 17 10 41 33 Excess Return 5.40 1.94 1.70 1.43 -0.84 0.18 2.20 1.82 5.46 2.08 2.17 3.45 5.92 5.21 4.97 4.28 4.02 3.62 3.50 3.57 3.93 3.49 2.13 1.25 3.17 1.38 2.11 3.68 5.85 5.20 2.53 0.55 0.94 1.81 6.24 2.35 0.93 2.38 4.78 2.99 1.75 A 1.75 0.47 0.41 0.40 -0.23 0.06 0.54 0.37 0.85 0.37 0.51 0.70 0.87 0.77 1.05 1.12 0.79 0.70 0.58 0.89 0.62 0.85 0.42 0.35 0.51 0.16 0.48 0.78 0.74 0.63 0.50 0.06 0.21 0.39 0.86 0.52 0.20 0.28 0.81 0.57 0.35 [t-stat] [1.73] [1.92] [1.85] [1.81] [-0.73] [0.19] [1.40] [1.16] [2.37] [1.60] [3.14] [7.33] [8.34] [8.59] [11.75] [11.82] [6.43] [4.53] [3.38] [5.08] [2.89] [4.24] [2.85] [2.04] [2.80] [1.15] [3.86] [5.50] [4.96] [3.50] [3.39] [0.41] [1.50] [2.58] [3.61] [2.33] [0.87] [1.15] [2.54] [3.48] [2.87] Table Correlations among demand for dividend measures, 1962-2000 The dividend premium PD-ND is the difference between the logs of the EW and VW market-to-book ratios for dividend payers and nonpayers The Citizens Utilities dividend premium PCU is the log of the ratio of the annual average cash dividend class share price to the annual average stock dividend class share price The initiation announcement effect A is the average standardized excess return in a three-day window [-1, +1] around the first declaration dates by new dividend payers Future relative returns rDt+1 – rNDt+1 is the difference in real returns for value-weighted indexes of dividend payers and nonpayers in year t+1 Future relative returns RDt+3 – RNDt+3 is the cumulative difference in future returns from year t+1 through t+3 P-values are in brackets Dividend premium ( Pt VW VW Pt EW Pt D  ND D  ND D  ND ) EW Future returns Pt CU At rDt+1 – rNDt+1 RDt+3 – RNDt+3 1.00 0.95 1.00 [0.00] Pt CU At rDt+1 – rNDt+1 RDt+3 – RNDt+3 0.60 0.63 1.00 [0.00] [0.00] 0.25 0.18 -0.20 [0.13] [0.27] [0.31] -0.21 -0.24 -0.28 0.16 [0.20] [0.15] [0.14] [0.35] -0.54 -0.47 -0.28 -0.19 0.63 [0.00] [0.00] [0.15] [0.27] [0.00] 1.00 1.00 1.00 Table Dividend policy and demand for dividends: Basic relationships, 1962-2000 Regressions of the propensity to pay dividends on measures of the dividend premium PTPt a  bPt D1 ND  cAt   dPt CU   ut A firm is defined as a new dividend payer at time t if it has positive dividends per share by the ex date (Item 26) at time t and zero dividends per share by the ex date at time t-1 The propensity to initiate dividends PTP New expresses payers as a percentage of surviving nonpayers from t-1 The propensity to continue paying dividends PTP Old expresses payers as a percentage of surviving payers from t-1 The propensity to list as a payer PTP List expresses payers as a percentage of new lists at t The dividend premium PD-ND is the difference between the logs of the EW and VW market-to-book ratios for dividend payers and nonpayers These data are shown in Table The announcement effects A are the average standardized excess returns in a three-day window [-1, +1] around the declaration dates of new dividend payers The Citizens Utilities dividend premium PCU is the log of the ratio of the annual average cash dividend class share price to the annual average stock dividend class share price The independent variables are standardized to have unit variance T-statistics use standard errors that are robust to heteroskedasticity and serial correlation up to four lags (1) D  ND VW Pt  (2) (3) Panel A: PTP Newt 3.90 [6.56] D  ND EW Pt  3.63 [5.10] CU 1.70 [2.21] At-1 N R2 38 0.60 D  ND VW Pt  38 0.52 28 0.11 Panel B: PTP Oldt 2.15 [2.51] 38 0.18 0.85 [2.83] D  ND EW Pt  0.93 [2.96] CU 0.44 [1.02] At-1 38 0.26 D  ND VW Pt  -0.52 [-0.82] 1.06 [1.52] 28 0.70 1.00 [2.59] Pt  N R2 (5) 3.80 [10.74] Pt  38 0.30 28 0.06 Panel C: PTP Listt 0.03 [0.09] 38 0.00 16.08 [6.29] D  ND EW Pt  -0.25 [-0.61] -0.24 [-0.87] 28 0.25 10.11 [2.12] 18.15 [7.12] CU Pt  14.74 [4.68] At-1 N R2 (4) 38 0.51 38 0.65 28 0.47 2.98 [0.58] 38 0.02 8.16 [1.64] -0.28 [-0.11] 28 0.63 Table Dividend policy and demand for dividends: Predicting returns, 1962-2000 Univariate regressions of future excess returns of dividend payers over nonpayers on the propensity to initiate, the propensity to continue paying, and the propensity to list as a payer The dependent variable in Panel A is the difference in real returns between dividend payers rD and nonpayers rND The dependent variable in Panel B is real return of dividend payers rD The dependent variable in Panel C is the real return of nonpayers rND Rt+k denotes cumulative returns from t+1 through t+k A firm is defined as a new dividend payer at time t if it has positive dividends per share by the ex date (Item 26) at time t and zero dividends per share by the ex date at time t-1 The dividend premium PD-ND is the difference between the logs of the value-weighted average market-to-book ratios of dividend payers and nonpayers The propensity to initiate dividends PTP New expresses new payers as a percentage of surviving nonpayers from t-1 The propensity to continue dividends PTP Old expresses continuing payers as a percentage of surviving payers from t-1 The propensity to list as a payer PTP List expresses new Compustat lists who are payers as a percentage of new Compustat lists In the PTP List specification, a year trend is included in the regression The independent variables are standardized to have unit variance We report OLS coefficients and bias-adjusted (BA) coefficients Bootstrap p-values represent a two-tailed test of the null hypothesis of no predictability PTP Newt N OLS BA [p-val] PTP Oldt R2 OLS BA [p-val] PTP Listt (detrended) R2 OLS BA [p-val] R2 0.10 -6.13 -6.87 [0.16] 0.07 Panel A: Relative returns rDt+1 – rNDt+1 37 -7.68 -6.54 [0.15] 0.10 -7.68 -7.97 [0.06] rDt+2 – rNDt+2 36 -13.27 rDt+3 – rNDt+3 35 -8.81 -12.63 [0.01] 0.31 -7.90 -8.20 [0.07] 0.11 -9.47 -9.49 [0.03] 0.15 -8.79 [0.06] 0.14 -5.90 -6.13 [0.17] 0.07 -7.08 -7.49 [0.09] 0.08 RDt+3 – RNDt+3 35 -30.54 -28.23 [0.06] 0.47 -21.62 -23.63 [0.13] 0.25 -24.88 -23.91 [0.10] 0.28 Panel B: Payer returns rDt+1 37 -4.06 -4.39 [0.29] 0.06 -2.14 -2.41 [0.46] 0.02 -3.11 -2.15 [0.36] 0.03 rDt+2 36 -0.95 -1.67 [0.79] 0.00 0.70 0.54 [0.85] 0.00 -3.00 -2.51 [0.31] 0.03 rDt+3 35 -1.87 -2.28 [0.60] 0.01 1.12 0.92 [0.73] 0.00 -2.88 -2.85 [0.34] 0.02 RDt+3 35 -8.08 -10.71 [0.39] 0.10 -0.16 -0.23 [0.99] 0.00 -8.19 -4.83 [0.37] 0.09 Panel C: Nonpayer returns rNDt+1 37 3.62 2.26 [0.64] 0.01 5.54 5.76 [0.38] 0.03 3.01 4.93 [0.62] 0.01 rNDt+2 36 12.32 11.02 [0.07] 0.13 8.60 8.73 [0.16] 0.07 6.47 6.83 [0.26] 0.03 rNDt+3 35 6.94 6.54 [0.31] 0.04 7.02 7.27 [0.28] 0.04 4.20 4.80 [0.47] 0.01 RNDt+3 35 22.46 17.45 [0.23] 0.18 21.47 24.81 [0.21] 0.17 16.70 19.88 [0.36] 0.09 Table Dividend policy and the dividend premium: Other controls, 1962-2000 Regressions of the propensity to pay dividends on measures of the dividend premium, growth opportunities, tax policy, and a time trend PTPt a  bPt D1 ND  c M D d  eTax t   fYeart   ut B t P t A firm is defined as a new dividend payer at time t if it has positive dividends per share by the ex date (Item 26) at time t and zero dividends per share by the ex date at time t-1 The propensity to initiate dividends PTP New expresses payers as a percentage of surviving nonpayers from t-1 The propensity to continue paying dividends PTP Old expresses payers as a percentage of surviving payers from t-1 The propensity to list as a payer PTP List expresses payers as a percentage of new lists at t The dividend premium PD-ND is the difference between the logs of the VW market-to-book ratios for dividend payers and nonpayers These data are shown in Table The VW marketto-book ratio M/B is averaged across nonpayers in Panels A, payers in Panel B, and new lists in Panel C The VW dividend yield D/P is from CRSP Tax is the difference between the top personal income rate and the top capital gains rate With the exception of year, the independent variables are standardized to have unit variance T-statistics use standard errors that are robust to heteroskedasticity and serial correlation up to four lags D  ND VW Pt  VW Nonpayer M/Bt-1 (1) (2) 2.83 [5.39] -1.92 [-2.43] 2.36 [4.26] -1.82 [-3.48] (3) (4) Panel A: PTP Newt 2.34 [7.04] -1.81 [-2.23] VW D/Pt-1 Taxt-1 1.19 [2.48] Yeart-1 N R2 D  ND VW Pt  VW Payer M/Bt-1 38 0.70 38 0.75 0.79 [2.64] 0.30 [1.05] 0.54 [2.08] 0.34 [1.45] 0.57 [2.27] Yeart-1 N R2 D  ND VW Pt  VW New List M/Bt-1 38 0.29 38 0.38 16.88 [7.75] 2.89 [0.76] 10.84 [5.88] 2.37 [1.42] 0.43 [1.57] 0.38 [1.52] Yeart-1 13.62 [7.67] 4.19 [6.53] 3.77 [7.25] 3.74 [4.40] 1.63 [3.05] 1.40 [2.94] 0.89 [1.71] 38 0.73 1.39 [2.10] 0.83 [1.61] -0.01 [-0.12] 38 0.73 0.83 [2.64] 0.52 [1.96] 0.39 [1.47] -0.16 [-0.82] -0.33 [-1.35] 0.65 [2.45] 38 0.38 -0.38 [-1.58] 0.40 [1.75] -0.03 [-0.71] 38 0.38 16.35 [5.67] 9.47 [5.09] 2.55 [2.80] 1.54 [0.47] -2.15 [-1.26] 14.39 [7.73] -5.27 [-4.50] 0.74 [0.74] -1.80 [-14.98] 0.33 [1.30] -0.03 [-0.68] 38 38 0.39 0.27 Panel C: PTP Listt 5.97 [3.56] 3.90 [3.36] VW D/Pt-1 Taxt-1 (6) 1.12 [2.05] -0.01 [-0.15] 38 38 0.75 0.70 Panel B: PTP Oldt VW D/Pt-1 Taxt-1 (5) 0.53 [0.34] -1.61 [-7.19] N R2 38 0.53 38 0.83 38 0.95 38 0.52 38 0.83 38 0.96 Table Dividend policy and the dividend premium: Firm characteristics controls, 1963-2000 Two-stage regressions of dividend policy on firm characteristics and the dividend premium The first stage performs Fama-MacBeth logit regressions of dividend policy on firm characteristics M dA E   Pr  Payerit 1 logit a  bNYPit  c d  e   uit B it A it A it   The second stage regresses the average annual prediction errors (actual policy minus predicted policy) from the logit regressions on the dividend premium ~ ~ PT Pt  f  gPt D1 ND  vt , where PT Pt  N1 i uit We perform this analysis on three subsamples The first two rows examine the propensity to initiate dividends PTP New and so restrict the sample to surviving nonpayers The next two rows examine the propensity to continue paying dividends PTP Old and so restrict the sample to surviving payers The last two rows examine the propensity to list as a payer PTP List and so restrict the sample to new lists The firm characteristics are the NYSE percentile NYP, the market-tobook ratio M/B, asset growth dA/A, and profitability E/A The NYSE percentile is the percentage of firms listed on the NYSE that are equal to or smaller in terms of market capitalization (PRC*SHROUT) The market-to-book ratio is the ratio of the market value of the firm to its book value Market value is equal to market equity at calendar year end (Item 24 times Item 25) plus book debt (Item minus book equity) Book equity is defined as stockholders’ equity (generally Item 216) minus preferred stock (generally Item 10) plus deferred taxes and investment tax credits (Item 35) and post retirement assets (Item 330) Asset growth is the change in assets (Item 6) over assets Profitability is earnings before extraordinary items (Item 18) plus interest expense (Item 15) plus income statement deferred taxes (50) over assets The dividend premium PD-ND is the difference between the logs of the VW market-to-book ratios for dividend payers and nonpayers These data are shown in Table T-statistics in the second stage regression use standard errors that are robust to heteroskedasticity and serial correlation up to four lags NYPt M/Bt dA/At D  ND VW Pt  E/At b [t-stat] c [t-stat] d [t-stat] e [t-stat] g [t-stat] PTP New 1.54 [10.65] -0.85 [-6.62] 0.21 [1.13] 9.60 [10.00] 3.35 [6.66] PTP New 0.90 [6.13] -0.23 [-1.48] 6.47 [12.42] 3.76 [6.71] PTP Old 4.57 [10.09] 0.33 [1.31] 1.50 [5.15] 15.06 [5.87] 0.34 [1.73] PTP Old 4.61 [10.63] 1.37 [4.96] 14.20 [6.01] 0.32 [1.56] PTP List 4.56 [40.95] -0.84 [-6.44] 10.76 [11.67] 11.20 [5.51] PTP List 3.88 [37.16] -1.19 [-8.64] 7.80 [13.06] 12.78 [6.99] -0.78 [-15.86] ... Initiating dividends serves as a signal in the models of Bhattacharya (1979), Hakansson (1982), John and Williams (1985), and Miller and Rock (1985) Again, a natural way to evaluate this explanation... overlap, the Poterba tax preference parameter has a correlation of –0.85 with our tax disadvantage measure 33 Returning to Table 7, one can see the effect of the tax disadvantage of dividends If anything,... for year t does not equal the number of Compustat New Payers in year t Another difference arises because the required CRSP data are not always available Given an initiation in calendar year t,