Relationship between the stock price and its determinants

Relationship between the stock price and its determinants

The relationship between the stock price and its determinants are summarized below:

Relationship between the stock price and its determinants

Econometric Analysis of the Variables

Corporate dividend policy is concerned with how much of its earnings a firm should pay to the shareholders. Alternatively, the retaining portion may be reinvested for the future earnings prospects of the firm. Retained earnings imply no concurrent tax liabilities. On the other hand, dividends are taxed at a flexible rate as applicable for individual shareholders. In spite of the tax treatment imposed by the government, corporations distribute a fraction of their earnings as dividends. By reducing their dividends, firms may raise the level of investment and therefore depress the rate of return on investment.

The return on investment is made up of cash dividends, capital gains (or losses) and capital distributions. It is assumed that the dividends and capital gains are equally valuable to the investors though this may not always be the case as tax treatments sometimes favor capital growth over dividends. But a firm may increase its retained earnings without having a return on capital to partly or wholly replace debt finance. A general question may arise in the mind of the shareholders that the corporate dividend policy affects their wealth. If an increase in dividends increases the value of the firm, the shareholders will prefer to take earnings as dividends and new investments should be financed through the sale of new securities.

But financial theorists find that dividend policy does not impact on share value although it affects the firm’s willingness to undertake its investment opportunities and thus impacts the firm’s value. However, the corporate owners want a share of the profits their firm earns. Considering the shareholders’ demand a firm may make dividend decisions recognizing the impact of the same on the shareholders’ wealth. For sure, theoretically, shareholders are indifferent between receiving corporate earnings as dividends and having a capital appreciation. Hence, the corporate dividend policy should have a relatively direct bearing on cyclical fluctuations and longer-term growth trends in the economy.

The appropriate ex-post measure of the return on equities is unambiguously total past income, i.e., dividends plus capital gains or losses on a stock over the market value of the same. But dividends plus recent capital gains or losses on a stock are not necessarily the best measure of ex-ante return. This is why capital gains and losses embody the capitalized value of any change in expected income and so are ordinarily larger than the change in expected income itself, which is the relevant quantity for the measurement of future return. Presumably, for this reason, investors more frequently use dividends plus retained earnings than dividends plus capital gains approximating future expected income for portfolio selection. Since corporate earnings paid out to common shareholders are not available for financing new investments, the corporate dividend decision is intertwined with corporate financial policy. Earnings per share measure the shareholders’ return. Shareholders’ return, in turn, implies the payment of dividends and/or capital gains. Employment of profits will enhance the shareholders’ equity and the shareholders’ earnings are the return on equity called net worth. Retention ratio multiplied by return on equity (ROE) measures the growth of a firm.

The retention ratio

The retention ratio is a percentage of net profit undistributed or retained by a firm. A firm retaining more may command a higher share price because of high growth in earnings. Shareholders of higher growth firms may obtain their return in the form of capital gains. But there is uncertainty regarding capital gains. Payment of dividends helps to resolve this uncertainty. The market price of slower growth firms’ shares, on the other hand, maybe lower. However, dividends are to be paid because it is the direct and most objective way of communicating to shareholders that their company is doing well although this does not make much sense in terms of growth. In this connection, a firm should accept all profitable projects implying that shareholders will reinvest their dividends in the share of the firm. However, firm’s dividend policies should be applied by considering some specific rules viz., net profit rule implying that dividends must be paid from past and current earnings, the capital impairment rule prohibiting payment of dividends from the capital account so that the shareholders and creditors are protected and the insolvency rule stating that the corporation may not pay dividends when insolvent.

The efficiency of capital markets

The efficiency of capital markets depends on the extent to which capital asset prices fully reflect information that affects their value. In a world of rational expectations, the firm’s dividend announcements provide just enough pieces of the firm’s sources and uses statement for the market to deduce the unobserved piece, to wit, the firm’s current earnings. Management of the firm should regard their shareholders as having a proprietary interest in earnings and urge the shareholders’ special interest in getting earnings in dividends, subject to their interest in the regularity of payment. Unless there are other compelling reasons to the contrary, fiduciary responsibilities of the management require them to distribute part of any substantial increase in earnings to the shareholders in dividends. Similarly, management believes that it is both fair and prudent for dividends to the shareholders to reflect any part of substantial or continuous decline in earnings and that under these circumstances shareholders should understand and accept the cut. Firms tend to increase dividends only when there is a high probability that cash flows in the future would be sufficient to support the higher rate of payment and dividends are decreased only when management is assumed that cash flows are insufficient to support the present dividend rate. It is obvious to argue that there should be a positive relation between dividend payments and share prices. Investors may have a preferred consumption pattern and the existence of transaction costs makes a particular dividend pattern a more desirable way to achieve their preferences than by selling securities. The market’s estimate of current earnings contributes in turn to the estimate of the expected future earnings on which the firm’s market value largely hinges.

The impact of dividend policy

The impact of dividend policy on the market value of a firm is a subject of a long-standing controversy. The major changes in earnings with existing dividend rates are the most important determinant of the firm’s dividend decisions. As the management believes that the shareholders prefer a steady stream of dividends, firms tend to make periodic partial adjustments toward a target payout ratio rather than dramatic changes in the payout. To gain an understanding of what determines the prices of a stock in addition to the dividends, this paper strives at considering and analyzing the factors affecting the price of an individual stock. The prices of stock will be determined by trading among individuals. Even if these stocks themselves are not directly traded, we can merely infer their prices in a competitive market from the prices of the stocks that are traded. To understand the stock market accurately, anyone will find some determinants that affect securities prices. It is logical to expect a relationship between corporate profits and securities prices. So, expected earnings and interest rates are the ultimate determinants of securities prices.

The transfer of capital between markets would raise the interest rate that affects the securities prices in two ways:

i) high rate of interest lessens the firm’s profits

ii) interest rates affect the economic activities that affect the corporate profits. Interest rates obviously affect the securities prices because of their effects on profits.

On Stock Return

Stock price behavior of the companies and its relation with explanatory variables like dividend payout ratio, stock dividends, right, retained earnings, earnings price ratio, size of company i.e. asset size, corporate governance like the number of directors, ownership pattern represented by sponsors’ shareholdings.

The relationship between stock return and explanatory variables is given by the following random-effect generalized least square (GLS) regression model:

Pooled data for the estimation can be used for the study purpose. These pooled data take care of the short-term influences of the transitory effects of the dependent and independent variables. Therefore, the combination of cross-section and time-series data is conducted to provide effective coefficient estimates. Relationship between the stock price and its determinants.

Read More: Bond Pricing Theorems