A Panel-Based Investigation Into the Relationship Between Stock Prices and Dividends

This paper investigates the presence of cointegration between stock prices and dividends for a panel of 56 large UK companies. Using new techniques which account for integrated processes in a panel context we demonstrate that stock prices and dividends are cointegrated, with an implied common discount rate of 5.8%. The authors would like to thank Rebecca Driver, Ronnie MacDonald and Peter Pedroni for helpful comments and for programs used in this paper. The usual disclaimer applies. 1 Of course, this simple relationship only holds in a world of certainty where investors have access to perfect information. Nevertheless, Shiller (1981) demonstrates that a similar relationship should hold in a world of uncertainty where investors have rational expectations. 2 For example, Arnold and Moizer (1984) reported that 87% of the 202 investment analysts in their survey “almost always” estimated future dividend yields when valuing shares. In Pike et al. (1993) dividend information was ranked third behind price/earnings ratios and net assets per share, in terms of usefulness for share valuation. 3 A small minority of authors have suggested that dividend cuts may not be seen as bad news by investors; instead, they may indicate that a company has profitable investments which it wishes to fund from internal cash resources. For example, Woolridge and Ghosh (1984) cite the example of Gould Inc. where the share price increased by 2% on news of a 60% cut in dividends; the authors suggested that Gould’s management had convinced the market that the reduction in dividends was to be used to fund innovative investment. 4 Researchers such as Watts (1973), Johnson and Jensen (1995) and De Angelo, De Angelo and Skinner (1996) argue that dividends do not act as a signal to investors about the future prospects of the firm. These authors point out that dividend changes tend not to be followed by earnings changes of the same sign. For example, they demonstrate that dividend cuts usually indicate that the firm has already experienced several years of financial pressure and are usually followed by earnings increases.