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THE IMPACT OF DIVIDEND AND CORPORATE EARNINGS ON STOCK PRICES

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CHAPTER ONE

INTRODUCTION

 

1.1       BACKGROUND OF THE STUDY

In a competitive economy, it is clear that investments are undertaken due to the available benefits perceived or which they provide to the investors.  Investment in securities are for the purpose of earning income which could be in form of dividends, profits or/capital gains. With this in mind, it could be said that no right thinking investor will put his funds if he does not expect some form of returns. Apart from the above reasons, prestige, power, control etc. could also be adduced, but primarily, the motive is to earn some form of returns.

Stocks or securities are documentary evidence of ownership or entitlement to claim upon the income and the assets of the issuing organization, which may be a publicly or privately owned institution. Investments in securities are carried out through a market known as the stock market, commonly referred to as the stock exchange, an example of which is the Nigerian stock exchange and it is the centre point of the Nigerian Capital Market (NCM).

 

The stock exchange as the hallmark constituency of the capital market is many things at the same time. It is a place where debt and equity securities of varying types are traded transparently. It is a market that facilitates capital mobilization  and allocation, as both governments and  companies can raise funds through the  market on long and most prudent terms  through the offer of shares (by companies) and bonds (by companies and governments) http://www.tritune.com.ng/izii2007/managment.html

 

The Securities and Exchange Commission (SEC) is the apex regulatory institution of the Nigerian capital market and is charged among other things with the responsibility of approving the price at which securities of all companies quoted on the stock market are to be listed. The principal objective of vesting this role on the SEC is to protect the generality of the investing public who are unsophisticated and therefore cannot understand the nature and operation of companies sufficiently to be able to appropriate value on their securities.

 

Economic analysts have discovered a number of factors affecting stock prices on the stock market. Among the factors affecting stock prices are:

 

  • Dividend policy of a company
  • Corporate earnings and
  • Volume of equity traded.

 

There has been a long standing controversy in academic circles as to which has greater impact/ influence on security prices. The dividend payment ratio is a major aspect of the dividend policy of the firm, which affects the value of the firm to the stock holders. The classical school of thought holds this view and they believe that dividends are paid to influence their  share prices and furthermore, they believe  that market price of an equity is a representation of the present value of estimated cash  dividends that can be generated by the equity. The new classical schools of thought on the other hand, believe that the price of equity is a function of the earnings of the company. They believe that dividend payout is in no way relevant to evaluating the worth of an equity. What matters, they said is earnings.

 

Retained earnings provide funds to finance the firms long – term growth. It is the most significant source of financing a firm’s investment. Dividends on the other hand are paid in cash, thus the distribution of earnings utilizes the available cash of the company. When the firm increases the retained portion of net earnings, shareholders’ current income in the form of dividends decreases, but the use of retained earnings to finance profitable investments is expected to increase future earnings on the other hand, when dividends are increased, shareholders current income will increase but the firm may be unable to retain earnings and thus relinquish possible investment opportunities and thus future earnings.

 

Management therefore is in a dilemma to device a dividend and retention policy that divides the corporate earnings into dividend and retained earnings in an optimum manner to achieve the objective of maximizing the wealth of shareholders. The interrelation of these decisions and the impact/effect they have on equity share prices in the Nigerian capital market is the focus of this paper.

 

Attempts will also be made to explain movement of stock prices through a third approach known as “Efficient Market Hypothesis”. This hypothesis seeks to explain that security prices adjust to new information released to the market. Taking into consideration the basic assumption that the market is very rapidly processed so that securities are properly priced at a given time. An important premise of an efficient market is that a large number of profit maximizing participants are concerned with the analysis and valuation of securities. The hypothesis assumes that no stock price can be in disequilibrium or improperly priced for a very long time. There is almost instantaneous adjustment to new information. The hypothesis applies most directly to large firms trading on the major security exchange. It further assumes that information travels in a random, independent fashion and that prices are an unbiased reflection of all currently available information.

 

Having mentioned this, in Nigeria, the question of dividend payments by companies before 1988 have not been regulated by the company Acts but also by section 4 (5) of Decree No 30 of 1997 which gave a ceiling they must not exceed when they pay dividends to their shareholders. Today, the questions of dividend payments have taken a new dimension. Although, they are still being governed by the company and banking Acts for companies and banks respectively, dividend payments have now being liberalized. This could be  evident in the productivity, prices and income board income policy guidelines (1988) which states that dividend payments  have now being deregulated. The levels of distributable dividends are now at the discretion of individual companies.

 

The Securities and Exchange Commission evaluates new issues principally by the maintainable annual earnings method.

 

This method takes into recognition the profit of the time and asset of the firm. It is considered and believed that when a firm’s assets are judiciously used, earning are increased which in turn enhances the value of the firm. Conversely, loses reduce that value of a firm in the eyes of the investing public. It is also in this regard that one finds the issue very interesting and the question now (which is the subject matter of this study) is “what is the relevant impact of dividends and earnings on security prices movements in Nigeria?

Therefore, in critically analyzing the impact of dividend and corporate earning policy decisions on equity share prices in the Nigerian capital market, a theoretical framework of the effect of dividend policy decisions on the value of the firm would be considered.

 

 

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