How Dividend Policy Affects Volatility of Stock Prices of Financial Sector Firms of Pakistan

American Journal of Scientific Research ISSN 1450-223X Issue 61(2012), pp.132-139 EuroJournals Publishing, Inc. 2011 http://www.eurojournals.com/ajsr.htm How Dividend Policy Affects Volatility of Stock Prices of Financial Sector Firms of Pakistan Mian Sajid Nazir Department of Management Sciences COMSATS Institute of IT, Lahore, Pakistan E-mail: sajidnazir2001@yahoo.com Tel: +92-322-4569868 Abdullah Institute of Business and IT University of the Punjab, Lahore, Pakistan E-mail: abdullah_ibit@yahoo.com Tel: +92-332-7390268 Muhammad Musarrat Nawaz Hailey College of Commerce University of the Punjab, Lahore, Pakistan E-mail: musaratnawaz@gmail.com Tel: +92-321-4217616 Abstract Corporate dividend policy is an important issue from the perspective of both the investors and the managers of the company because abrupt change in the prices of the stock indicates its riskiness. The main purpose of this study is to determine the effect of dividend policy on the volatility of stock prices of the financial sector firms of Pakistan listed in the Karachi Stock Exchange after controlling for earning v0latility, assets growth, firm size and leverage. Fixed effect regression analysis was performed to see the impact of dividend policy on the stock price volatility. The results showed that there is significant negative relationship between dividend yield and price volatility and also between dividend payout and price volatility in KSE listed firms. The study indicates that dividend policy is an important tool in setting share prices in emerging economy like Pakistan. Keywords: Dividend policy, Stock prices, Price volatility, Dividend yield, Dividend payout 1. Introduction Corporate dividend policy has remained a very important but also an ambiguous matter in the history of corporate finance. Many researchers have tried to determine the outcome of corporate dividend policy on the value of the firm but there are conflicting views about this. Therefore it is open for further debate and conversation until a single point of agreement is reached. The influence of dividend policy on the value of a firm was given importance after the work by Modigliani and Miller (1958) and Miller and Modigliani (1961). They presented the view that a firm s value is not related with its

How Dividend Policy Affects Volatility of Stock Prices of Financial Sector Firms of Pakistan 133 dividend policy and it takes into account only its earning power. The shareholders are not interested in receiving cash flows as dividends or capital gains, in a perfect market. This view is only true under the condition if investors have the same information about financial position of the company as do managers have, Bhattacharya (1979). However, there are some investors which prefer present cash streams rather than expected future cash flows in the form of capital gain; Gordon and Walter (1963). They stated that dividend payout influences stock price volatility. From the perspective of agency theory presented by Jenson & Meckling (1976), managers could be incapable to maximize shareholders wealth because of differing interests. The basic problem arises because of the separation of control and ownership which in turn results in agency conflicts. Management can use these retained earnings in low return on investment projects due to their own monetary benefits and interests. Therefore, maximum portion of the firm s earnings should be paid as dividends rather than keeping as retained earnings. In this way, there will be less money in the hands of managers and it will decrease their authority on resources which otherwise could be used for their personal interests or could be invested in non profitable projects. A furtherer explanation of agency theory was presented by Easterbrook (1984) and argued that payment of large portion of earnings can solve the issue of combined actions that tends to lead to under monitoring of the corporations and its managers. So, distribution of dividends to shareholders and subsequent raise of debt encourage examination of the firm by third parties like investment banks and other regulatory authorities of the government. This screening lowers the agency costs and causes the firm s market value to rise. Jenson (1986) argued that if large portion of earning is paid as dividend, firm s value would be increased because there would be less free cash flow in hands of manager. It will decrease their power and they would have fewer funds available to invest in projects of negative NPV or of their own welfare. There are many researchers who have worked on this topic with the reference of developed countries, however, very few of them worked in the context of emerging economies like Pakistan. One of them was conducted by Nishat and Irfan (2001) and another was done by Nazir et al (2010). The purpose of this study is to determine the role of dividend policy (by taking its two parameters, dividend yield and dividend payout ratio) on the stock price volatility of the firms in the financial sector of Pakistan s capital market. There may be numerous factors that can affect volatility of the stock prices. These may include companies growth opportunities, earnings, leverage or total debt ratio and size etc. This study is different from the previous ones in the following ways: It is conducted on financial sector firms listed in stock exchange in the emerging market like Pakistan. Financial data of a sample of 75 companies is collected and has been empirically examined. Data of most recent years from 2006 to 2010 makes it more reliable as Pakistani capital market has undergone major changes since 2008. 2. Previous Research Corporate dividend policy has been a much researched topic for more than 6 decades. Despite of much discussion on this issue, no specific conclusion has been withdrawn. It is important for not only investors but also for management to decide an optimal dividend policy because dividend policy can ultimately affect stock prices. Thus, we can say that volatility in stock prices is a measure of the riskiness associated with it. Miller and Modigliani in 1961 presented dividend irrelevance theory by taking the assumption of perfect capital markets. They argued that investors are indifferent towards receiving cash flows in the form of dividends or as capital gains. The only thing they assume is the investment opportunities. Dividend payout affects residual free cash flow and after that firms decide to pay dividends if any free cash is left. Firms paying large dividends are exposed to less risk of stock price volatility, Gordon and Walter (1963). Friend and Puckett (1964) tried to find out the link between dividend and share prices in the United States. They used control variables which could influence a firm along their study variables.

134 Mian Sajid Nazir, Abdullah and Muhammad Musarrat Nawaz They identified that a dollar of dividend had a significant impact on the value of the retained earnings. They found a positive relationship between dividends and stock prices of firms with a little or no growth potential. The stocks of the firms with huge investment opportunities are unlikely to be affected by the dividends. Miller & Scholes (1978) presented Tax Effect Theory. According to this theory, different rates of tax on dividend income and capital gains make different clientele. Taxable investors can be indifferent to dividends even when the tax rule favors capital gains. Individuals in low tax brackets may prefer firms which pay high dividends. Large investors, who own most of the stock of the firm, are in high tax brackets and will always prefer firms with low payout policy. Investors choose firms regarding their preference of dividends and capital gains. No firm can increase its value by changing its dividend payout policy as there are many firms to satisfy all types of investors. Bhattacharya (1979) suggested that due to information gap among all the stakeholders of the firm, dividend payout policy plays an important role in conveying information about the financial health of a company. It is an important tool to signal the earnings estimation of the firm to a widely dispersed body of shareholders and it benefits in a way that liquidation is increased by paying actual amount of dividend. Although high tax is deducted on cash dividend yet they provide idea about expected returns of the firm in the future and cause stock prices to move upward or consistently. Litzenberger and Ramaswamy (1982) carried out a research in United States by taking data of 21 years. They proved that fluctuations in stock prices are due to information or tax effects of dividends. They argued that there is positive correlation between common stock returns and dividend yields. However, this relationship is non linear. Baker et al (1985) in USA tried to find out role of dividend on stock prices by taking more than five hundred firm listed in NYSE. They identified a significant relationship between them. Baskin (1989) identified a negative affiliation between dividend yield and stock price volatility meaning that higher dividend yield will lead to low volatility in stock prices. The relationship was significant in his study. Catering theory was presented by Baker and Wurgler (2004). The main concept of this theory is that the decision to pay dividend is dependent on the demand of the shareholders or investors. Managers should cater the needs of the shareholders and initiate dividends when they want them and they are paying premiums on the stock, and should not pay when they want non payers. Hussainey et al (2011) conducted a study in the United Kingdom to find relation of dividend yield and payout on stock market of UK. They took data of 10 year period of public listed companies and run least square regression analysis. They found a negative relationship between dividend payout and stock price volatility and positive for dividend yield and price volatility. In control variables, debt is positively associated and size is negatively related with price volatility. Amidu and Abor (2006) conducted a study on the determinants of dividend policy by using panel data of 20 firms listed in Ghana Stock Exchange. Dividend payout ratio was taken as dependent variable. They proved that dividend payout was mostly dependent on the net earnings of the firms also those firms with high liquidity pay high dividends. The association of dividend payout with risk is negative in nature. Rashid and Rehman (2008) conducted a study in Bangladesh. They took 104 non financial firms for a period of 1999 to 2006. They found a positive but non-significant relationship between dividend yield and stock price volatility in the capital market of Dhaka Stock Exchange. They also found that there is no considerable relation between declaration of earnings and the stock prices as seen in the developed capital markets. The insignificant relationship between stock price volatility and dividend policy may be due to inefficient capital market of Bangladesh or due to majority of shares held by dominant shareholders also working in the company board. Nishat and Irfan (2001) also found significant impact of dividend payout and dividend yield on stock price volatility in emerging market like Pakistan. Another study was done by Nazir et al (2010) on the non-financial firms listed in Pakistan s capital market. The data of 73 firms was analyzed for a six year period from 2003 to 2008. After using panel data and applying regression analysis, they also found a negative and significant relationship between both measures of dividend policy (i.e., dividend yield and dividend payout ratio) and stock price fluctuations. Khan et al (2011) also investigated the effect of dividend policy on share price reactions of fifty five non-financial firms listed in Karachi

How Dividend Policy Affects Volatility of Stock Prices of Financial Sector Firms of Pakistan 135 Stock Exchange. Results of their study after using regression on panel data identified a positive link between dividend yield and negative relation of retention ratio with the share price movements. H 0 : There is no relationship between dividend policy and stock price volatility. H A : Dividend Policy is negatively related with stock price volatility. H 01 : Dividend Yield does not affect stock price volatility H a1 : Higher the dividend yield lower the volatility in stock price H 02 : Dividend payout does not affect stock price volatility H a2 : Higher the dividend payout ratio lower the volatility in stock price 3. Research Method: Variables Measurement Price Volatility Price volatility is the dependent variable measuring movement in price changes and thus measuring risk of the stock. It is calculated for every stock by taking the difference between highest and lowest stock prices in the year and dividing by the average of highest and lowest prices and then by taking the square of it. Dividend Yield It is the measure of the independent variable. It is calculated by taking all cash dividends paid to common stock holders in a year and then dividing them by the average market value of the shares in the year. The formula is given as under: Dividend Payout Ratio DPR is calculated as the total cash dividends paid within a year divided by the total earnings after tax or net income. Earnings Volatility To limit the effect of changes in earnings stream on price volatility, this control variable is introduced. EVol is calculated as moving average standard deviation of the net earnings of the firms. Assets Growth This variable is the difference between the opening and closing value of assets in the year divided by the total value of assets of the last year. To calculate the AG of year 2006, total assets of 2005 have also been taken. Size Size of the firms can also be associated to price fluctuations because large organizations are considered to be diversified in their risk while small ones are less known in the market and their stocks are less liquid in nature and thus more volatile. So, control variable of size has been made. Size is taken as the natural logarithm of average market value of common stock Leverage Leverage can also affect volatility of stock prices. So, it has been introduced as a control variable. Leverage is calculated as the ratio of total debts to total assets.

136 Mian Sajid Nazir, Abdullah and Muhammad Musarrat Nawaz 3.1. Sampling and Methodology The sample size is of 75 financial firms listed on the exchange for a continuous period of 5 years from 2006 to 2010. Only those companies have been taken whose data was easily available. Merged, demerged, newly registered and delisted firms during this period have not been selected. In order to test the hypothesis i.e. accept or reject the null hypothesis, Regression analysis has been performed. Fixed effect regression has been run on the panel data to find out the real relationship between the dependent variable and two independent variables. Four control variables i.e. earnings volatility, assets growth, size and leverage, have also been introduced to find the clear association between dependent and independent variables. 3.2. Model The model used is similar to that of Baskin (1989) and Allen and Rachim (1996). Price volatility is taken as dependent variable to be measured and dividend yield and payout ratio as independent variables. The basic regression equation is as follows: PVol = α + β 1 DY + β 2 DPR + ε DY and DPR are likely to be related and other factors can affect volatility. To overcome this issue, introduction of control variables makes the model as: PVol = α + β 1 DY + β 2 DPR + β 3 EVol + β 4 AG + β 5 Sz + β 6 Lvg + ε For the purpose of estimating the research models for hypotheses testing first, a sample of companies listed in Tehran Stock Exchange for the time period of 2001-2003 is used. Second, a sample of state companies is used. We estimate the research models with pooled data for three years, and overall 647 years-firm. Then, similarly the models are estimated for sample companies in different industrial groups. Finally, we estimate the research models using cross-sectional data for each year (2001 to 2003). We estimate the research models for the sample of state companies in the same way. 4. Results and Discussion The first variable in the list is price volatility, which has a minimum value of.009 and a maximum of 3.54 and having a mean value of.75. The median value is.5 and skewness is 1.57, kurtosis is 2.39 that is near to 3 meaning data is peaked whereas standard deviation is 0.67. Independent variables dividend yield and DPR having mean of.054 and.38 respectively. Dividend yield ranges from 0 to.52 with a dispersion of.077 whereas DPR ranges from -11.92 to 18.5 having standard deviation of 1.45. Skewness for DY is 1.7 and for DPR 4.9. The kurtosis value for DPR is 84.7 which mean that data is highly peaked. Control variable earnings volatility has a mean value of 560.8. Its skewness is 3.7 and kurtosis is 15.7 with a dispersion or standard deviation of 1282.8. The minimum value is.023 and maximum value of 8473. Assets growth is on the average.19. Table 1 indicates maximum decrease in the value of total assets of -.97 and maximum increase of 9.92. Kurtosis is 64.246 which show the peak is very high. By seeing another control variable size of firm in the table 1, the average size is 6.86 and median is 6.34 with standard deviation of 2.29 and with highest value of 12.27 and lowest of 2.58. The skewness of size variable is approximately.4 (data is symmetrically distributed) and Kurtosis is negative i.e., -.709 indicating flat data distribution. Last control variable in the table is leverage (Lvg). The Leverage has a mean value of.58 with a median of.5. The minimum value for Lvg is.003 and maximum 19.9. The kurtosis value 227.29 which is highest among all variables showing a highly peaked data distribution. Table 1: Descriptive Statistics Mean Median Std. Deviation Skewness Kurtosis Minimum Maximum PVol.7522.5003.6733 1.575 2.391.0092 3.5395

How Dividend Policy Affects Volatility of Stock Prices of Financial Sector Firms of Pakistan 137 Table 1: Descriptive Statistics - continued DY.0544.01028.07671 1.720 3.927.0000.5248 DPR.3810.000000 1.4533 4.928 84.742-11.9206 18.5065 EVol 560.8610 64.4429 1282.8509 3.734 15.731.0233 8473.1160 AG.1976.0807.8819 7.160 64.246 -.9703 9.9189 Sz 6.8529 6.3424 2.2973.399 -.709 2.5840 12.2699 Lvg.5845.5014 1.14328 13.997 227.297.0033 19.9444 Table 2 shows the correlation among different variables. It shows significant negative relationship of DY with the dependent variable PVol meaning that higher the dividend yield, lower the fluctuation in the shares prices and this relationship is significant at 1% level of significance. DPR is also negatively related with the PVol and it is non significant relationship. EVol is showing positive relationship with PVol and it is significant at approximately 100 percent confidence level. EVol is negatively related with DY meaning higher earnings volatility lower the dividend yield will be. EVol has also a significant positive relationship with dividend payout ratio at a 5% level of significance. AG has inverse and not significant relationship with all variables PVol, DY and DPR. AG is positively linked with earning volatility. Size of the firm is inversely related with PVol. However, with DY a significant negative relation is found. The total debt indicated by Lvg is non-significant and positively related with PVol. DY and AG are negatively correlated with Lvg which has a significant positive relationship with Sz meaning that higher the leverage the larger the size of the firm. Table 2: Correlation Matrix PVol DY DPR EVol AG Sz DY Pearson Correlation -.227 ** DPR Pearson Correlation -.039.309 ** EVol Pearson Correlation.138 ** -.112 *.116 * AG Pearson Correlation -.059 -.015 -.013.091 Sz Pearson Correlation -.085 -.138 ** -.005.541 **.099 Lvg Pearson Correlation.005 -.009.043.057 -.094.125 * Table 3 below shows that the relationship of DY with PVol is negative and significant. This means that price volatility decreases with the increase in dividend yield and PVol increases with the decrease in dividend yield. Similarly, DPR is also negatively associated with PVol however it is very insignificant relationship. In control variables, EVol has a positive relationship with PVol and it is very strong relationship. If earnings of a firm are volatile its price volatility is also high and if earnings volatility decreases then there is decrease in price volatility. AG, Sz and Lvg are inversely linked with PVol. The relationship of Sz with PVol is significant. This means that larger firms face lower price volatility and small firms are more exposed to risk in terms of share prices. So, we have been able to empirically confirm that the relationship of PVol with DY and DPR is negative. Table 3: Fixed Effect Regression Fixed-effects (within) regression Number of obs = 375 Group variable: company2 Number of groups = 75 F(6,294) = 4.74*** pvol β Std. Err. t-value P>t [95% Conf. Interval] dy -1.756785.6035171-2.91 0.004-2.944546 -.5690233 dpr -.0010944.0261897-0.04 0.967 -.0526375.0504487 evol.000126.0000507 2.49 0.013.0000262.0002257 ag -.0535036.0400495-1.34 0.183 -.1323236.0253165 sz -.1941849.0721146-2.69 0.007 -.3361111 -.0522587 lvg -.0025766.0340022-0.08 0.940 -.0694952.0643419 cons 2.12025.4991531 4.25 0.000 1.137884 3.102617

138 Mian Sajid Nazir, Abdullah and Muhammad Musarrat Nawaz 5. Conclusion We have investigated the role of dividend policy of the financial sector firms on their stock price movements in emerging economy like Pakistan. We examined the effect of dividend yield and dividend payout (independent variables) on stock price volatility (dependent variable) by taking data of 75 financial firms listed in the Karachi Stock Exchange. Control variables of earnings volatility, assets growth, leverage and size were also included to find out the obvious relationship and magnitude of the variables. After collecting data for a five year period from 2006-2010, correlation and regression analysis was performed on panel data. Results rejected the null hypothesis and we have been able to state that the DY and DPR both have negative relationship with dependent variable with PVol. The relationship of DY with PVol is significant. Earnings volatility has also significant positive relationship with the price volatility. Hence we can say that the dividend policy is an effective way to guide the market value of the financial firms in emerging economy like Pakistan. References [1] Allen, D.E. and Rachim, V.S. (1996), Dividend policy and stock price volatility: Australian Evidence, Journal of Applied Economics, Vol. 6, pp. 175-88. [2] Baskin, J. (1989). Dividend Policy and the Volatility of Common Stock. Journal of Portfolio Management, 15 (3), 19-25. [3] Battacharya, S. (1979), Imperfect information & dividend policy and the bird in hand fallacy, The Bell Journal of Economics, Vol. 10, pp. 259-70. [4] Conroy R. M., Eades, K. M. and Harris, R. S. (2000). A Test of the Relative Pricing Effects ofdividends and Earnings: Evidence from Simultaneous Announcements In Japan. The Journal of Finance, 55 (3), 1199-1227. [5] Fama, E. F., and K. French. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(4), 427-465. [6] Fama, E. F. (1991). Efficient capital market: II, Journal of Finance, 46, September, 1575-617. [7] Friend, I. and Puckett, M. (1964). Dividends and Stock Prices. The American Economic Review, 54 (5), 656-682. [8] Gordon, M. J. (1963). Optimal Investment and Financing Policy. Journal of Finance, 18 (2), 264-272. [9] Harkavy, O. (1953). The Relation between Retained Earnings and Common Stock Prices for large Listed Corporations. Journal of Finance, 8 (3), 283-297. [10] Hussainey, K.; Mgbame, C. O. and Chijoke-Mgbame, A.M. (2011), Dividend policy and share price volatility: UK evidence, The Journal of Risk Finance,Vol. 12 No. 1, pp. 57-68. [11] Imran, K. (2011). Determinants of Dividend Payout Policy: A Case of Pakistan Engineering Sector. The Romanian Economic Journal, XIV (41), 47-60. [12] Jensen, M. C. (1986). Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economic Review, Papers and Proceedings, 76: 323-329. [13] Litzenberger, R. H. and Ramaswamy, K. (1982), The Effects of Dividends on Common Stock Prices: Tax Effects of Information Effects, The Journal of Finance, 37 (2): 429-443. [14] Lintner, J. (1962) Dividends, Earnings, Leverage, Stock Prices and the Supply of Capital to Corporations Review of Economics and Statistics, Vol. 64(3): 243-69. [15] Miller, M. and Scholes, M., 1978, Dividends and taxes, Journal of Financial Economics, Vol. 6 No. 4, 333-64. [16] Modigliani, F. and Miller, M. H. (1958). Dividend Policy, Growth, and the Valuation of Shares. American Economic Review, 48 (3), 261 297. [17] Nazir, MS.; Nawaz, M.M.; Anwar, W. and Ahmed, F. (2010), Determinants of Stock Price Volatility in Karachi Stock Exchange: The Mediating Role of Corporate Dividend Policy. International Research Journal of Finance and Economics, 55, pp 100-107.

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