Testing validity of Lintner's dividend model

INTRODUCTION

In this project an attempt will be made to test Lintner's Dividend Model. For this purpose real time data of earning per share and dividend per share will be used for at least 30 UK companies over the time frame of 10 - 15 years and are regressed as independent variable against the change in dividend figure, which is the dependent variable in our case, to see whether it is explained by the independent variables.

One of the most important decisions that a large number of firms have to make repeatedly in their lives is that of dividends. Although this decision, as we will see later in the paper, is made each year but is not made afresh. It is rather dependent on the decisions made on dividend payments in the previous years. These decisions are of such a consistent nature that the whole process is termed as a policy, 'the dividend policy'.

The dividend policy decisions are of much importance because of their perceived and also observed effect on the prices of the shares. There is a long and ongoing debate about this issue, which is still very much inconclusive. One of the great scholars in finance, famous for having developed Black and Scholes Model, Fisher Black, puts in his paper named 'The Dividend Puzzle': "What should the individual investor do about dividends in his portfolio? We don't know. What should the corporation do about the dividend policy? We don't know." The Dividend Puzzle (Black, 1976)

The traditional view is that dividend policy of a firm does matter in its valuation and a policy change can significantly affect a company's share price. This point of view was well represented in the writings of Graham and Dodd, as they put it in their famous book on security analysis, saying: "... the verdict of the stock market is overwhelming in favour of liberal dividends as against niggardly one. The common stock investor must take this judgement into account in the valuation of stock for purchase. Two companies with the same general earnings power and general position in the Industry, the one paying the larger dividend will almost always sell at a higher price" B Graham & D L Dodd, "Security Analysis: Principles & Techniques", 3rd Ed., McGraw Hill 1951.

Contrary to the claim by Graham and Dodd, Miller and Modigliani in their much debated paper, 'Dividend Policy, Growth and the Valuation of Shares', argued that the company's dividend policy is irrelevant to its valuation. This debate is discussed in much depth in the Literature Review section of the paper.

The dividend debate remains important in its own place, but a big contribution was also made by John Lintner in 1956 by presenting a model that, according to him, was highly effective in explaining the dividend policy behaviour of the companies. During my dissertation we will test his dividend model by using the data on UK companies from different industries to see whether the claim made by Lintner is validated by our results.

BACKGROUD STUDY & LITERATURE REVIEW

The literature on the dividend policy broadens our understanding about dividend policy. During this research I will try to find the answers to the questions that have been addressed by the researcher community in all these years, for example, why dividend policy is so important for the management of the companies and also for the investors who have a stake in them by holding their stocks? And can a company increase its value by just changing its dividend policy?

The most significant contribution that is still recognised as the basis of the current understanding of the dividend debate can be traced back from 1961 when an article named 'Dividend Policy, Growth, and Valuation' was published, written by Merton H. Miller and Franco Modigliani, which provided the basis for the idea that the dividend policy of any company is irrelevant to its market value. This argument is termed as the dividend irrelevancy proposition or argument.

It was a breakthrough of its time because it was generally believed at that time, that the companies that pay a larger amount of their earnings as dividends were valued higher in the market as compared to those that paid ungenerously from their earnings. Graham and Dodd in their book on security analysis had put it this way: "Two companies with the same general earning power and general position in an industry, the one paying the larger dividend will almost always sell at a higher price" B Graham & D L Dodd, "Security Analysis: Principles & Techniques", 3rd Ed., McGraw Hill 1951.

Miller and Modigliani (1961) opposed the above view by saying that given the investment policy of a company, the dividend policy is irrelevant for the valuation of a firm. The basic argument by Miller and Modigliani was that the payment of dividend is a flow of the assets from a company to its shareholders in the form of cash. The idea that transferring cash from the company to its owners creates value seems to be absurd if deeply thought about. As they put it in their article by saying:

"Like many other propositions in economics, the irrelevancy of dividend policy, is 'obvious once you think of it'. It is after all, merely one more instance of the general principle that there are no 'financial illusions' in a rational economic environment. Values are determined solely by real considerations - in this case the earning power of the firm's assets and its investment policy - and not on how the fruits of the earning power are 'packaged' for distribution." Miller and Modigliani (1961)

In 1956 John Lintner did a remarkable addition to the literature in finance that provided an insight to the dividend policy decisions and the factors that influence these decisions. He provided the basis for new horizons to be explored in the much complex area of corporate dividend policy. Lintner (1956) noted that dividend decisions are not a by product of investment or savings decisions, rather companies follow a somewhat more stable and well establish dividend policy and current decisions are made with reference to the previously followed pattern, hence savings decisions are dependent on dividend policy and are rarely a product of the current decisions.

He studied the dividend policy of 28 firms, hand picked to cover firms with different circumstances and characteristics like size, because, he argued, the industrial sector had more diverse dividend policy, that's why the firms were chosen from broadly defined industrial sector. Intensive study was made to identify the critical factors that were brought into consideration each time the management had to make a dividend decision.

Key observations of Lintner's study were that companies follow a rather stable dividend policy with a target payout ratio in mind and current earnings were almost always a factor taken into consideration. Current dividends are determined on the basis of the previous dividends rather than making a decision afresh each period. It was also noted that Managers are more reluctant to cut dividends and only have an increase if it is highly likely that they will not have to roll back on their decision in the foreseeable future.

He argued that this continuing partial adaptation protects the company shares from adverse shareholder reaction as a result of smoother dividend stream and provides the management a cushion against the uncertainties that they have to live with. Putting in his own words, "Generally speaking, after these standards had been established or embodied informal understandings, the company lived with them and undertook all of its financial planning and capital budgeting in the light of these standards of dividend behaviour. Managements deliberately planned ahead so that carrying through their established dividend policy would not involve them in unduly short liquidity positions. Management was generally in a position and was willing to draw down on working capital to help meet such requirement" John Lintner (1956)

On the basis of his findings he developed a theoretical model of corporate dividend behaviour, which was named after his name as the Lintner's Model. It takes the following equation form:

ΔDit= at + ct (D*it - Di (t-1)) + Uit

Where,

  • ΔDit is the change in dividend
  • at is the constant term
  • ct is the speed of adjustment
  • D*it is current year's dividend
  • Di (t-1) is the previous year's dividend
  • Uit is the error

Lintner (1956) reported that his model was able to explain 85 percent of the changes in dividends in his sample.

OBJECTIVE & SCOPE OF THE STUDY

The aim of this research is to test the Lintner's Dividend Model that how the model is setup and how Lintner conducted his study to reach a model that, he argued, explained the dividend behaviour of the companies in general. In order to achieve this aim the first step of proposed objectives will be the detailed studies of Lintner's Model (1956) as well as the 4th proposition of Miller & Modigliani (1961) and after that we will do some empirical, data, statistical and regression analysis on real time data of some UK companies in order to test the validity of Lintner's Model as dissertation project.

RESEARCH METHODOLOGY

TYPE OF DATA

The type of data used in this project will be secondary in broad terms and to some extent content analysis could be the part of this research as well. As we know that secondary data research involves an analysis of existing data that were collected during the conduct of primary research study as well as it also involves background work i.e. literature review, case studies, published texts, and statistics.

SOURCES OF SECONDARY DATA

The main expected sources of secondary data will be journals, newspapers, books, published texts and our university or other university's databases having information regarding average payout ratio and EPS and dividend run of UK companies. During this study we might consider some case studies as well in order to do quality empirical and data analysis.

TYPE OF ANALYSIS

Content analysis is the study to include certain words and concepts within the text. Two methods of content analysis, relational analysis and conceptual analysis could be considered in examining the data during this research. Furthermore, I am planning to take the companies from different type of industries to show the validity of Lintner's Model.

LIMITATIONS OF THE STUDY

The most important issue could be the acquisition of 100% correct information from companies regarding their financial policies. Another important thing is that there are different school of thoughts having different views regarding dividend policy and much literature review is available as well, but debate is still going on and it remains an important issue in its own place.

SUMMARY & CONCLUSION

In this proposal, we have reviewed two different views regarding dividend policy. According to one school of thought, the dividend policy of a firm does matter in its valuation and a policy change can significantly affect a company's share price and other practitioners believed that the dividend policy decisions are of much importance because of their perceived and also observed effect on the prices of the shares. Miller and Modigliani (1961) disagree with the above view by saying that the given investment policy of the company, the dividend policy is irrelevant for the valuation of the firm, on the basis of some assumptions.

In 1956, John Lintner noted that dividend decisions are not by product of investment or saving decisions; rather companies follow a somewhat more stable and well establish dividend policy and current decisions are made with reference to the previously followed patterns, hence saving decisions are dependent on dividend policy and are rarely a product of the current decisions. Although we have not yet conducted analysis to test Lintner's model but some studies and literature review shows contradictory results and others are providing supportive evidences, so, there still exists a great scope of explore the dividend policy and solve the unsolved puzzle.

According to the initial planning, after introduction the first section of research project will be literature review, in which the dividend irrelevancy argument of Miller and Modigliani and the views of other experts will be discussed in detail. Section two will contain the discussion on Lintner's Dividend Model, how model is setup and how Lintner's conducted his study to reach a model that, he argued, explained the dividend behaviour of the companies in general. In the final section of the project will be the analysis section. After all it can be said that time will be the limiting factor in carrying out this research project, and a full depth of study can be conducted.

REFERENCES

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  • Allen, Franklin and Michaely, Roni (2002), 'Payout Policy' Working Paper The Wharton Financial Institutions Centre.
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  • Lintner, John (1956), 'Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes', The American Economics Review, Vol. 46, pp. 97-113.
  • Miller, Merton and Franco Modigliani (1961), 'Dividend Policy, Growth and Valuation of Shares', Journal of Business, Vol. 34, pp. 411-433.
  • Pettit, R. Richardson, (1972), 'Dividend Announcements, Security Performance, and Capital Market Efficiency', Journal of Finance, 27(5), pp 993-1007
  • Watts, Ross (1973), 'The Information Content of Dividends', Journal of Business, 46(2), pp 191-211.

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