The Pricing of Dividends in Equity Valuation

This paper employs Ohlson's (1995, 1998) accounting based equity valuation model to structure an empirical assessment of the pricing of dividends in stock prices. We address two questions. First, to what extent does the pricing of dividends reflect Modigliani and Miller?s (1958, 1961) one-to-one displacement property? Second, what explains the direction and magnitude of any divergence from dividend displacement? Using annual cross-sections of NYSE, AMEX and NASDAQ firms over the period 1974-1996, we find robust evidence that dividends are materially positively priced, sharply contrasting with the negative relation predicted by dividend displacement. We also find that the positive pricing of dividends is at least three times larger for loss firms than for profit firms. Our explanation for these results is that managers of loss firms use dividends to signal future profitability, while to a lesser degree managers of profit firms use dividends to alleviate concerns about the misuse of free cash flow. We conclude that dividends are a component of, and rich proxy for, other information about future abnormal earnings that is reflected in price but is not yet captured by current financial statements.