Information Content of Dividends and Share Repurchases*

Information Content of Dividends andShare Repurchases*

Inbong HaDivision of Economy and Trade, Kyungpook National University

Gwangheon Hong**College of Business, Sogang University

Bong Soo LeeCollege of Business, Florida State University

Received 18 May 2011; Accepted 2 June 2011

Abstract

Share repurchases have become a popular means of paying out cash to shareholders, and one

of their often cited motives is their signaling of undervaluation of repurchasing firms.

Dividends are often viewed as signaling future earnings. However, in theory, signaling of

current undervaluation should be closely related to signaling of future cash flows. In the

present study, it is found that broad dividends, which include both narrow cash dividends

and share repurchase, signal both current undervaluation and future cash flows. This suggests

that dividends and share repurchases are complementary in their signaling role by paying out

permanent and temporary earnings, respectively.

Keywords Signaling; Share repurchases; Dividends; Broad dividends; Information asymmetry

JEL Classification: C32, G35

1. Introduction

The most common methods that corporations use to distribute cash to their share-

holders are regular cash dividends and share repurchases. One of the significant

trends in corporate finance in last thirty years is the increasing popularity of stock

*Acknowledgments: We would like to thank Kevin Krieger and seminar participants at the

University of Houston, the University of Iowa, Texas A&M University, Korea Advanced Insti-

tute of Science and Technology, Ewha University, and Florida State University for useful

comments. This research was supported by WCU (World Class University) program through

the National Research Foundation of Korea funded by the Ministry of Education, Science and

Technology (R32-10240).

**Corresponding author: Gwangheon Hong, College of Business, Sogan University. 1 Shinsoo-

Dong, Mapo-Ku, Seoul, Korea 121-742. Tel: (82)-2-705-8530, Fax: (82)-2-705-8519, email:

[email protected].

Asia-Pacific Journal of Financial Studies (2011) 40, 517–549 doi:10.1111/j.2041-6156.2011.01048.x

� 2011 Korean Securities Association 517

repurchase programs. Share repurchases have increased over time and now consti-

tute an economically important source of payouts.1

A widely discussed explanation for dividends and repurchases is that corporate

managers use them to signal their optimism about the firm’s prospects. There are

two different versions of this signaling issue. One is to convey the management’s

expectation of future increases in the firm’s earnings and cash flows that is not

shared by the market (i.e. the cash flow signaling hypothesis). The other is to express

disagreement with the market’s valuation of the firm’s performance (i.e. the under-

valuation hypothesis). Other motives often mentioned for the recent increases in

repurchase activities might reflect, in part, a broad tax-motivated substitution of

repurchases for dividends. Others emphasize that share repurchases are used to pay out

cash flows that are potentially temporary, thus preserving financial flexibility relative

to dividends because they do not implicitly commit the firm to future payouts.

An interesting observation from previous studies on the signaling role of the

two types of cash payouts is that, although there are some debates, the conventional

cash dividends tend to be explained based on the cash flow signaling hypothesis,

whereas share repurchases tend to be discussed based on the undervaluation

hypothesis. However, both hypotheses are based on information asymmetry between

inside corporate managers and outside investors.2 Furthermore, the two hypotheses

should be closely related in theory in the sense that if managers foresee a future

increase in cash flows (or earnings), which outside investors do not see, then the

firm should be undervalued. Therefore, we seem to have incomplete interpretations

of the signaling role of the two types of cash payouts.3 In the present paper, we

attempt to provide new insight into this puzzling observation.

To better understand this puzzling observation, we propose an empirical

framework that tests the presence of information asymmetry and signaling of future

cash flows. By extending this framework, we further propose a model for identifying

undervaluation and overvaluation of stock prices. By applying these methods, we find

that conventional cash dividends (the actual cash paid to shareholders), which we call

narrow dividends, are mainly associated with future cash flow signaling, whereas share

repurchases are mainly associated with the current undervaluation of stock prices,

which confirms previous findings. However, when we use broad dividends, which we

define as the sum of (narrow) cash dividends and share repurchases, we find that the

1According to Grullon and Michaely (2002), the announced value of share repurchases

increased from US$1.5bn to US$194.2bn between 1972 and 2000. In contrast, dividends rose

from US$17.6bn to US$171.7bn. Fama and French (2001) find that the percentage of firms

paying cash dividends fell from 66.5% in 1978 to 20.7% in 1998.2Oded (2009) explores the implications of inside information and adverse selection associated

with share repurchase programs. His model predicts that the completion rate of repurchase

programs and bid–ask spreads are negatively correlated.3Kao and Chen (2011) find that dividend payment and stock repurchase are not substitutes

following the elimination of double taxation of dividends in the Taiwan stock market.

I. Ha et al.

518 � 2011 Korean Securities Association

broad dividends are associated with both cash flow signaling and current undervalua-

tions. Our finding suggests, among other things, the importance of using a broad

definition of dividends, which has become more popular recently, to better under-

stand the puzzling behavior of the components of the broad dividends (e.g. Ackert

and Smith, 1993; TeSelle, 1998; Robertson and Wright, 2006; Boudoukh et al., 2007).

One way to understand these findings would be to note that between the two

means of signaling management optimism about a firm’s prospects to the market,

managers tend to use dividends to pay out permanent earnings and repurchases to

pay out temporary earnings (e.g. Guay and Harford, 2000; Jagannathan et al., 2000;

Lee and Rui, 2007).4 Because permanent earnings tend to be persistent and tempo-

rary earnings tend to be non-persistent by nature, dividends tend to better predict

future earnings compared to share repurchases. When the market price deviates

from the fair value temporarily, in particular when undervalued, share repurchases

tend to be related to this by paying out temporary earnings.

The rest of the paper is organized as follows. In Section 2, we briefly review the

related published literature. In Section 3, we present an empirical framework and

methodology to test information asymmetry and the cash flow signaling hypothesis.

We extend the model to address the test of the undervaluation hypothesis, in partic-

ular the identification of undervaluation. In Section 4, we introduce our data, and

in Section 5 we discuss the empirical results of various tests. We provide further

analyses in Section 6, and conclude in Section 7.

2. Background

2.1. Future Cash Flow Signaling

Prior studies have documented that the stock market reacts positively to dividend

increases and negatively to dividend decreases (e.g. Pettit, 1972, 1977; Laub, 1976;

Charest, 1978; Aharony and Swary, 1980; Asquith and Mullins, 1983; Brickley, 1983;

Bajaj and Vijh, 1990). Various hypotheses have been proposed to explain the

market’s reaction to dividend changes. The primary explanation has been the (cash

flow) signaling hypothesis. Early examples include Lintner (1956) and Miller and

Modigliani (1961). This dividend information hypothesis has been further formalized

in theoretical models by Bhattacharya (1979, 1980), Hakansson (1982), Miller and

Rock (1985), John and Williams (1985), Kumar (1988), Ambarish et al. (1987),

Ravid and Sarig (1991), Lee (1996, 1998), and Kumar and Lee (2001). In these

models, managers are typically assumed to have more information about the value of

the firm’s assets in place than outside investors do. Managers use dividend changes to

communicate information about cash flows to the outside market, but at a cost.

4Hertzel and Jain (1991) find that stock price reactions to repurchase announcements are

positively correlated with analysts’ revisions in short-term forecasts, but not correlated with

revisions in long-term forecasts. Thus, the information is primarily about transitory changes

in earnings.

Dividends and Share Repurchases


Empirical research on the signaling hypothesis of dividends provides mixed

evidence regarding the relation between dividend changes and future earnings.

Watts (1973) was among the first to examine the relation between dividends and

future earnings, and he finds a weak, positive relation between an unexpected

change in dividends and a change in future earnings. Subsequently, Gonedes (1978),

Penman (1983), and DeAngelo et al. (1996) find little evidence linking dividend

changes to subsequent earnings surprises.

In contrast, Asquith and Mullins (1983) and Healy and Palepu (1988) find that

firms that initiate dividends had significant increases in earnings in the past and for

at least 1 year afterward (see also Lipson et al., 1998). Brickley (1983) and Aharony

and Dotan (1994) find evidence that earnings continue to rise after increases in

dividends (see also Brook et al., 1998). DeAngelo et al. (1992) find that dividend

reductions are more likely if managers envision future difficulties in earnings.

Benartzi et al. (1997) find evidence that dividend changes ‘‘signal’’ (reflect) the

past and the present but not the future (see also Grullon and Michaely, 2002).

However, somewhat consistent with the signaling hypothesis and the permanent

earnings hypothesis, they also find that firms that raise dividends are less likely to

experience a drop in future earnings than firms that do not raise dividends (see

Lintner, 1956; Lee, 1996, 1998; Guay and Harford, 2000; Kumar and Lee, 2001).

However, Nissim and Ziv (2001) find that dividend changes are positively related to

earnings changes by taking into account potential measurement errors in earnings

change and omitted correlated variable.

Empirical studies also document significantly positive stock price reactions to

stock repurchase announcements.5 An explanation for the sizable stock price increases

is that repurchase announcements reveal favorable information about the future pros-

pects of the firm, just as dividends do. The signaling models of dividends by Bhattach-

arya (1979) and Miller and Rock (1985) can be extended to repurchases as well. This

is because in their models, dividends and share repurchases are perfect substitutes so

that a given amount of payout conveys the same information to shareholders, regard-

less of the payout channel choice.6

5See, for example, Vermaelen (1981), Dann (1981), Lakonishok and Vermaelen (1990), Com-

ment and Jarrell (1991), Ikenberry et al. (1995, 2000), and D’Mello and Shroff (2000). Lie

(2005) finds that actual repurchases, and not announcements per se, portend future perfor-

mance improvements in operating performance.6This is particularly the case if repurchases are commitments, not just an announcement of the

option to repurchase stocks on the open market, and the model is based on one period. The

model by John and Williams (1985) predicts that only dividends can convey information

regarding a firm’s prospects to shareholders. This is mainly because a signal needs to be costly

to be credible and dividends are more costly due to higher tax than tax on capital gains in their

model. In Ofer and Thakor (1987), however, share repurchases constitute a stronger signal

because they involve an additional cost for managers, which stems from the increase in risk of

their portfolios, as managers usually do not tender their shares during repurchase programs.

I. Ha et al.


However, the empirical evidence on the signaling cash flow by share repurchases

is mixed. Dann (1981), Masulis (1980), and Vermaelen (1981) suggest that managers

try to use share repurchases to signal the information about increases in the firm’s

earnings or declines in the firm’s risk to the market. Bartov (1991) finds some evi-

dence that positive earnings surprises occur in the same year as a repurchase (see

also Dann et al., 1991). However, Lie and McConnell (1998) find little evidence that

repurchase tender offers are followed by improved earnings. Furthermore, Grullon

and Michaely (2004) document that the announcements of open-market share

repurchases are not followed by increased operating performance.

2.2. Undervaluation Signaling

According to the undervaluation hypothesis, share repurchases are used by managers

to reveal information about equity undervaluation. If managers believe that the firm

is undervalued relative to their superior private information, then they might attempt

to disclose this potentially value-increasing information by repurchasing the firm’s

stock. Ofer and Thakor (1987) present a model that predicts that a firm with a large

undervaluation will use a share repurchase to reveal this information, whereas a firm

with a small undervaluation will use a dividend-increase signal. The undervaluation

hypothesis is consistent with the significantly positive announcement period returns

documented by empirical studies (e.g. Vermaelen, 1981; Choi and Chen, 1997).

Stephens and Weisbach (1998) find that share repurchases are negatively related to

prior stock price performance, which suggests that firms increase their repurchase

depending on their degree of perceived undervaluation. Dittmar (2000) examines vari-

ous share repurchase hypotheses and finds information signaling based on potential

undervaluation to be the major motive throughout the sample period. Baker et al.

(2003) survey 642 top financial managers to study their opinions about share repur-

chases from January 1998 to September 1999. They find that undervaluation is the most

highly cited reason for repurchasing shares (see also Wansley et al., 1989; Brockman and

Chung, 2001; Oswald and Young, 2004; McNally et al., 2006; Babenko et al., 2010).7

7Oswald and Young (2004) find that despite the prevailing regulatory environment, under-

pricing still represents an important determinant of repurchase activity for the UK. Babenko

et al. (2010) show that executives who buy shares of their firm before an announcement add

credibility to the undervaluation signal. They find that announcement returns are positively

related to past insider purchases, especially for firms that are priced less efficiently and do

not repurchase with intention to deploy cash or increase leverage.

By analyzing an extensive database of individual repurchase trades from the Toronto Stock

Exchange, McNally et al. (2006) find evidence consistent with two hypotheses: repurchases

provide price support and the market learns that the shares are undervalued. Consistent with

the latter, they find that repurchasing companies have superior timing. Consistent with the

information-asymmetry hypothesis, Brockman and Chung (2001) find that managers exhibit

substantial timing ability in that they find strong evidence that bid–ask spreads widen and

depths narrow during repurchase periods.



Based on extensive surveys and interviews, Brav et al. (2005) find a clear pattern

that payout policy, for both dividends and share repurchases, conveys information

and that firms repurchase when their stock is a good value, relative to its true

value.8 In contrast, they find that dividend policy is not greatly affected by stock

price. Therefore, unlike the cash flow signaling hypothesis that is associated with

both dividends and share repurchases, the undervaluation hypothesis appears to be

mainly associated with share repurchases.

3. Empirical Framework and Methodology

3.1. Information Asymmetry, Earnings Process, and Payout Policy

In this section 3.1, we provide a framework in which there is information asym-

metry between inside managers and outside investors. In such cases, payout deci-

sions can convey new information about future earnings (or cash flows). In fact,

some payout decisions can be informative events (i.e. forward-looking), whereas

others can be non-informative events (i.e. backward-looking) with respect to

future earnings. The payout decision is related to future earnings when it is an

informative event under information asymmetry. The idea is that, although inside

managers and outside investors observe the same financial variables, such as cur-

rent and past earnings and payouts, investors might not recover all the informa-

tion managers use in setting new payouts. Our framework is very useful because it

provides a regression model that tests the information asymmetry and the predic-

tive power of payouts.

As in most other studies, the analysis in the present paper relies on the assump-

tion that the relation between lagged earnings and future earnings is linear. However,

there is empirical evidence that the dynamic behavior of earnings is highly nonlinear.

For example, Brooks and Buckmaster (1976), Elgers and Lo (1994), and Fama and

French (2000) find that large changes in earnings revert faster than small changes and

that negative changes revert faster than positive changes. When the true relation is

nonlinear, the linear modeling of variables can cause some specification problems.

However, nonlinear modeling of variables makes our analyses very limited. In the

present paper, we recognize the potential problem associated with the assumption of

linear modeling, but we do not pursue this problem further, assuming that the linear

model might provide a reasonable approximation to the true relation.

Here, we utilize a theorem in time-series econometrics, which states that any

time-series process has both invertible and non-invertible representations (see

8Choi et al. (2009) find that Japanese firms with large deviations between cash flow rights

and voting rights are likely to announce large amounts of stock repurchases to increase both

the cost of toehold and the price of the offer. They also find that keiretsu-affiliated firms are

most aggressive in repurchasing shares when their cash flow rights and voting rights are far

off from alignment.

I. Ha et al.


Fuller, 1976, theorem 2.6.4). Suppose, for the expositional simplicity that outside

investors, observing current and past earnings, infer a first-order moving average,

MA(1), process of the first-differenced earnings:9

DYt ¼ ð1� kLÞut ; jkj< 1:0; ð1Þ

where DYt (= Yt ) Yt)1) is the change in earnings at time t, L is the lag (or

backshift) operator (i.e. Ln Yt = Yt)n), and ut is white noise with varðutÞ ¼ r2u. The

autocovariance functions (ACF) for this earnings process are:

varðDYtÞ ¼ ð1þ k2Þr2u;

covðDYt ;DYt�1Þ ¼ �kr2u;

covðDYt ;DYt�kÞ ¼ 0; for k � 2:

ð2Þ

Suppose that managers, observing the same current and past earnings, infer the

following MA(1) process of the earnings process:

DYt ¼ ð1� k�1LÞvt ; ð3Þ

where vt is white noise with varðvtÞ ¼ r2v . The ACF for this earnings process are:

varðDYtÞ ¼ ð1þ k�2Þr2v ;

covðDYt ;DYt�1Þ ¼ �k�1r2v ;

covðDYt ;DYt�kÞ ¼ 0; for k � 2:

ð4Þ

Note that if we set r2v ¼ k2r2

u, then the ACF in equations (2) and (4) are identi-

cal. Because the earnings process can be identified in practice by the observed ACF,

the identical ACF imply that earnings processes in equations (1) and (3) represent

the same earnings process. That is, for a given earnings process, investors and

managers might infer different MA(1) processes due to information asymmetry.10

In addition, r2v is smaller than r2

u because r2v ¼ k2r2

u and jkj< 1:0. This means that

the variance of the one-step-ahead forecast error of the earnings process in equa-

tion (3) by managers would be smaller than the corresponding variance of the earn-

ings process in equation (1) by investors. However, unlike the ut process, the vt

process cannot be fully recovered by outside investors from the information about

9For simplicity, we use an MA(1) model of a first-differenced earnings process, assuming that

earnings levels are a non-stationary process, whose empirical evidence will be discussed

below. Any higher order representation of earnings would yield the same results.10The earnings process in equation (1) with the innovation ut is an invertible moving average

representations because the root of the determinant of the moving average representations of

DYt is greater than 1 (i.e. det [1 ) kz] = 0, for z = k)1). However, the earnings process with

the innovations vt in equation (3) is a non-invertible moving average representations because

the root of the determinant is less than 1 (i.e. det [1 ) k)1 z] = 0, for z = k).



current and past values of earnings.11 In sum, although both managers and inves-

tors observe the same (current and past) earnings, under information asymmetry,

inside managers with a larger information set, X�t ¼ fDYt�j; vt�j; ut�j; for j � 0g,can forecast future earnings better than outside investors with a smaller information

set, Xt ¼ fDYt�j; ut�j; for j � 0g.We obtain an important alternative insight by comparing the corresponding

autoregressive representations of the moving average representations of earnings

processes {DYt} in equations (1) and (3):

ut ¼ ð1� kLÞ�1DYt ¼X1j¼0

kjDYt�j; and

vt ¼ ð1� k�1LÞ�1DYt ¼ �ðkL�1Þð1� kL�1Þ�1DYt ¼ �X1j¼1

kjDYtþj:

We obtain these by solving backward for ut because jkj< 1:0, and forward for vt

because jk�1j< 1:0.

Note that the innovations {ut} in the investors’ earnings process are backward-

looking, whereas the innovations {vt} in the managers’ earnings process are for-

ward-looking.12 That is, investors observing current and past earnings can recover

the information contained in the ut, but they might not recover all the information

contained in the vt of managers’ earnings.

How is this information asymmetry between inside managers and outside inves-

tors related to the dynamic relation between payouts and earnings (i.e. the predic-

tive (signaling) power of payouts)? Suppose that managers, who have an

informational advantage in that they can forecast the firm’s future prospects (e.g.

future earnings) better than outside investors by observing vt, use this information

in their payout decisions. Then, informative payouts (XIt ) are a function of innova-

tion vt, which inside managers observe but outside investors do not:

XIt ¼ f ðvtÞ ¼

X1i¼0

ðhiLiÞvt ¼

X1i¼0

hivt�i, withX1i¼0

h2i <1:

where ðXIt Þ is the informative payout. Then, the informative payout and earning

processes will be related as follows:

11This is because the process is not invertible.12The innovations {ut} are represented by a square summable linear combination of current

and past values of ‘‘DYt’’s (i.e. ut lies in the space spanned by current and lagged ‘‘DYt’’s).

However, the innovations {vt} are represented by a square summable linear combination of

future values of ‘‘DYt’’s (i.e. vt lies in the space spanned by future ‘‘DYt’’s). This is because if

we solve equation (3) backwards, the right-hand side is not square summable.

I. Ha et al.


XIt ¼

X1i¼0

ðhiLiÞvt ¼

X1i¼0

ðhiLiÞfð1� k�1LÞ�1DYtg

¼X1i¼0

ðhiLiÞ �

X1j¼1

kjDYtþj

!¼X1

j¼�1djDYt�j;

where dj for j = )¥, …, )2, )1, 0, 1, 2, …, ¥ is a function of hi and kj. That is,

this informative payout is a linear combination of future, current, and past earn-

ings; thus, this is considered forward-looking.

In contrast, suppose that managers do not have an informational advantage or

they simply do not make payout decisions based on their informational advantage.

Then, the non-informative payout ðXNIt Þ will be a function of the innovation that

outside investors observe, ut:

XNIt ¼ f ðutÞ ¼

X1i¼0

ðhiLiÞut ¼

X1i¼0

hiut�1, withX1i¼0

h2i <1:

Then, this non-informative payout and earning processes will be related as

follows:

XNIt ¼

X1i¼0

ðhiLiÞut ¼

X1i¼0

ðhiLiÞð1� kLÞ�1DYt

¼X1i¼0

ðhiLiÞX1j¼0

kiDYt�j

( )¼X1k¼0

dkDYt�k;

ð6Þ

where dk for k = 0, 1, 2, …, ¥ is a function of hi and kj. That is, this non-informa-

tive payout only reflects the past and current earnings and is not related to future

earnings; therefore, it is considered backward-looking. To summarize, we have

shown that under information asymmetry, informative payouts (XIt ) are related to

not only past and present earnings but also future earnings. In contrast, in the

absence of information asymmetry, non-informative payouts ðXNIt Þ are not related

to future earnings.

How do we distinguish between the two types of payouts: informative and non-

informative? The above discussion suggests that when a firm makes a payout deci-

sion, if it conveys new information about future prospects of the firm that is not

contained in the current and past values of earnings and payouts, then it is an

informative (i.e. forward-looking) payout and is related to future earnings. Other-

wise, it is a non-informative (i.e. backward-looking) payout. Whether payout deci-

sions are informative or not can be empirically tested using the following

proposition.

The equivalence of the two-sided equation in (5) with causality has been estab-

lished by Sims (1972, theorem 2), which we restate in our context:



Proposition 1. Consider the following two-sided regression:

Xt ¼ aþXm

j¼�m

djDYt�j þ et ; ð7Þ

where E(et, DYt)j) = 0 for all j (= )m, … )1, 0, 1, … m). If the null hypothesis that

all the coefficients of future earnings are zero (i.e. dj = 0 for all j < 0) is rejected,

then Xt causes DYt.

That is, we can use the Sims’ two-sided regression-based causality test as a

means of testing the predictive power of payout decisions for future earnings, and

the finding of the predictive power of payout decisions can be interpreted based on

information asymmetry. Therefore, this framework can be used for any other

predictability tests of financial decision variables. Our framework is consistent with

theoretical signaling models of dividends (e.g. Miller and Rock, 1985) in that signal-

ing is effective when marginal information conveyed by forward-looking dividends

is above that of current and past earnings.

3.2. Cash Flow Signaling

As discussed above, we use Sims’ two-sided regression-based causality tests to exam-

ine the cash flow signaling hypothesis of share repurchases and dividends. Consider

the following two-sided regressions:

ðRP=YÞt ¼ aþXm

j¼�m

cjDYt�j; ð8Þ

ðD=YÞt ¼ aþXm

j¼�m

cjDYt�j; ð80Þ

where RP ⁄ Y is the repurchase payout ratio, D ⁄ Y is the dividend payout ratio, and

DYt is earnings changes. If the null hypothesis H0: cj = 0 for j = )1, )2, …, )m in

equation (8) (or equation 8¢) is rejected (i.e. future cj coefficients are statistically

significant), then share repurchases (or dividends) cause (i.e. help predict) future

earnings and they are informative payouts. In this case, if the sum of future

coefficients,P�1

j¼�m cj, is significantly positive, then share repurchases (or dividends)

signal future increases in earnings. If a v2-test does not reject the hypothesis that

cj = 0 for j = )1, )2, …, )m, then share repurchases (or dividends) do not cause

earnings, and they are non-informative payouts.

3.3. The Undervaluation Hypothesis

3.3.1. Identification of Undervaluation

To examine whether payouts are related to undervaluation, we need to have a

measure of undervaluation (or overvaluation). We identify the undervaluation as

the difference between the fundamental component of price (i.e. fair value or

intrinsic value) and the actual price. The fundamental component is defined as the

I. Ha et al.


part of the price that is related to such fundamentals as earnings and dividends.

Therefore, in estimating a fundamental value (or intrinsic value), our approach

can be viewed as a variation of an earnings-based valuation model (e.g. D’Mello

and Shroff, 2000) or the residual income model and ⁄ or the dividend-based (e.g.

usual dividend discount model) valuation model. When the actual stock price is

below the fundamental component of the stock price, we say the stock is under-

priced.

Recall that informative cash payouts, XIt , are related to future earnings, whereas

non-informative payouts, XNIt , are not related to future earnings. When we assume

that the dividend discount model for stock valuation (i.e. stock price is the expected

present discount value of future dividends) and the dividends are informative cash

payouts, XIt , then stock price is a function of not only current and past earnings

but also future earnings. Therefore, based on these informative payouts, managers

have superior information about future earnings and can identify the fundamental

component of price and the undervaluation and overvaluation of stock price.

However, if the dividends are non-informative cash payouts, XNIt , then stock price

is a function of only current and past earnings and managers do not have superior

information about future earnings. Hence, in this case, including dividends in the

model might not help identify the fundamental component of price and the under-

valuation and overvaluation of stock price.

To identify the fundamental and non-fundamental components in stock price,

we consider a 3 · 1 vector, Z1t, consisting of the first differenced earnings (DYt),

the dividend payout ratio (Dt ⁄ Yt), and the price–earnings (PE) ratio (Pt ⁄ Yt):

Z1t = [DYt, Dt ⁄ Yt, Pt ⁄ Yt]¢.13 By the Wold theorem, Z1t has the following trivariate

moving average representation:

Z1t ¼ ½DYt ;Dt=Yt ; Pt=Yt �0 ¼ CðLÞet ; or

DYt

Dt=Yt

Pt=Yt

264

375 ¼

C11ðLÞ C12ðLÞ C13ðLÞC21ðLÞ C22ðLÞ C23ðLÞC31ðLÞ C32ðLÞ C33ðLÞ

264

375

ey1t

ed2t

enf3t

264

375 ; ð9Þ

where et is a 3 · 1 vector consisting of ey1t ; e

d2t , and e

nf3t ;e

y1t = earnings shock; ed

2t =

dividend shock; enf3t = non-fundamental shock; CijðLÞ ¼

Pk ck

ijLk

h iwith

Pk�

P1k¼0

for i, j = 1, 2, and 3 is a polynomial in the lag operator L; and the disturbances

(innovations) are orthonormalized such that var(et) = I.

The above representation implies that earnings, dividend payout ratios, and

PE ratios are driven by fundamental shocks and non-fundamental shocks (or

13We could have considered DP instead of P ⁄ Y as the third variable in the trivariate moving

average representation model. Even though DP is more stationary than P ⁄ Y, it is hard to

interpret that investors identify the undervaluation or overvaluation of prices based on the

price changes. Instead, the PE ratio (P ⁄ Y) seems both natural and is more often used as a

measure of undervaluation or overvaluation.



disturbances), and the fundamentals are represented by earnings and dividends.14

The coefficient ck13 measures the effect of the third (i.e. non-fundamental) shocks

(enf) on the first variable (i.e. earnings changes) in k periods so that the restric-

tion C13ðLÞ ¼P

k ck13 Lk ¼ 0 implies that the effect of the non-fundamental shocks

(enf) on earnings is zero. Therefore, the requirements that the non-fundamental

shocks (enf) do not affect earnings and dividends are represented by the

coefficients in C13(L) and C23(L) being zero (e.g. Lee, 1998). In addition, we

impose the restriction that the dividend shocks (ed) do not affect earnings (i.e.

C12(L) = 0).15

Proposition 2. In the above trivariate moving average representation, fundamental

and non-fundamental shocks to (or components of) PE ratios are characterized by

the following restrictions on Z1t:

C12ðLÞ ¼ C13ðLÞ ¼ C23ðLÞ ¼ 0 ½or ck12 ¼ ck

13 ¼ ck23 ¼ 0; for all k�: ð10Þ

Once we identify the fundamental and non-fundamental shocks to (or components

of) the PE ratios, the non-fundamental components of the PE ratios and the market

prices are identified by ½C33ðLÞenf3t � and ½Y�t C33ðLÞenf

3t �, respectively.

The restrictions in equation (10) are, in fact, imposed on the trivariate vector

autoregressive representation of Z1t. We provide the proof of Proposition 2 in

Appendix. In the Appendix, we also discuss how the restriction on the trivariate

moving average representation is implemented.

3.3.2. Tests of the Undervaluation Hypothesis

Once we identify the non-fundamental component of the PE ratios, ðP=YÞnft ¼

C33ðLÞenf3t , we can derive the non-fundamental component of the market prices by

multiplying it by earnings: Pnft ¼ Y�t C33ðLÞenf

3t (see Proposition 2). Notice that the

non-fundamental component is the difference between the observed PE ratio (or

market price) and its fundamental component, and, therefore, the difference repre-

sents a measure of overvaluation. To see whether share repurchases (or dividends)

are related to undervaluation, we regress share repurchases (or dividend changes) on

the non-fundamental components of the PE ratios (or prices) and examine the signs

of the coefficients. If share repurchases (or dividends) are related to the undervalua-

tion, then we expect a significant negative sign for the coefficient. Given the potential

non-synchronous timing of the data, we look at the sum of the three period (i.e.

m = 3) lead and lag coefficients. That is, in the following regressions,

14We extend this trivariate model to a four-variable model, adding time-varying interest rates

as another fundamental variable later in Section 6.1.15This assumption does not affect our identification and derivation of the non-fundamental

component of prices. However, it helps us to identify the separate role of dividends (e.g. Lee,

1998). The change in ordering between DYt and Dt ⁄ Yt does not affect our analysis and result.

I. Ha et al.


RPt ¼ aþXm

j¼�m

cj Pnft�j; ð11Þ

DDt ¼ aþXm

j¼�m

cj Pnft�j ð110Þ

we test the null hypothesis H0:Pm

j¼�m cj ¼ 0. If this null hypothesis is not rejected,

then share repurchases (or dividends) are not related to the undervaluation. If this

null hypothesis is rejected and the sum of coefficientsPm

j¼�m cj is significantly

negative, then share repurchases (or dividends) are significantly associated with

undervaluation.

4. Data and Preliminary Results

As in previous studies on share repurchases, we use the actual repurchase in our

analysis. Previous studies point out some problems associated with some alterna-

tive measures (e.g. the change in treasury stock, the net dollar spent on

repurchases as reported in the firm’s cash flow statement, or the change in the

number of shares outstanding as reported on the CRSP or Compustat databases).

We obtain ‘‘total value repurchased ($mil)’’ from the repurchases section under

the worldwide mergers, acquisitions and alliances listing of SDC Platinum. SDC

Platinum is an Internet database platform provided by Thomson Reuters. It

includes all US repurchases (open market and privately negotiated) and self-tender

transactions. The sources of SDC Platinum are SEC Filings, such as 10Ks and

10Qs; surveys of companies with programs; and news sources such as Reuters,

Dow Jones, the Wall Street Journal, the New York Times, and others. It covers

more than 5000 repurchases for the period of 1992:1–2010:4.16 This database

contains the most comprehensive sample of open market share repurchase

programs available and covers most of the share repurchase programs announced

after 1992.17 We focus on the firms included in the S&P 500 to be analyzed with

prices and dividends. We use the monthly dataset in this study. The monthly data

for the P ⁄ E, dividend yield, and S&P 500 price index are obtained from

Datastream. We construct the (value-weighted) aggregate share repurchase index

by calculating the ratio of the total repurchase amount of all the S&P 500 firms

16Stephens and Weisbach (1998) identify 450 actual repurchase programs using The Wall

Street Journal Index. SDC Platinum collects the repurchase data from more comprehensive

sources. Jagannathan and Stephens (2003) employ the same dataset in their study.17Because our sample begins in 1992, we do not discuss the effect of regulatory changes due

to the Securities and Exchange Commission adoption of rule 10b–18 (i.e. safe harbor rules)

in late 1982, which helped reduce the regulatory ambiguity and the associated litigation risk.



every month to the market capitalization of the S&P 500 index.18 Then, we con-

vert nominal variables into real variables using CPI inflation.

As a preliminary step, Table 1 reports the results of unit root tests for the vari-

ables used in our models. We use both the augmented Dickey and Fuller (1979) test

and the Phillips and Perron (1988) test, while we recognize that the power of the

tests is debated. The models in the previous section anticipate that earnings, Yt, div-

idends, Dt, and stock prices, Pt, are non-stationary, while share repurchases, RPt, are

stationary. The test results show that the null hypothesis of a unit root in earnings

(Y), dividends (D), and prices (P) is not rejected, while a unit root in share repur-

chases (RP) is rejected, confirming our conjecture.19 Both the dividend payout ratio,

(Dt ⁄ Yt), and the share repurchase payout ratio, (RPt ⁄ Yt), are stationary by both

tests. The PE ratio, (Pt ⁄ Yt), appears to be stationary, as it is widely used in practice

and in our paper.20 All three measures of broad dividends, BDt (= Dt + RPt), BDEt

(= (D ⁄ Y)t + (RP ⁄ Y)t), and BDDt (= DDt + RPt), which will be used in later

sections, are stationary by both the augmented Dickey–Fuller tests and the Phillips–

Perron tests with the most number of lag lengths.

In the present paper, we use aggregate data to investigate the time-series properties

in the aggregate payout policy. Several prior studies have also used aggregate data on

share repurchases (e.g. Bagwell and Shoven, 1989; Jagannathan et al., 2000; Dittmar

and Dittmar, 2004). Using the data on an individual firm level, payout might be

preferred in general. However, even for a firm, some payouts might be informative

and others might be non-informative. Furthermore, individual firms usually do not

have regular, recurrent share repurchase activities as in dividend payouts. Thus, it

would be very difficult to apply our testing method, which is based on a time-series

regression. Using aggregate data would make more sense for the purpose of the pres-

ent paper. In addition, earnings smoothing and manipulation are less likely to affect

the analysis at the aggregate level than at the firm level, and by using aggregate data

we can overcome the problem of cross-sectional correlations in earnings and payouts.

18The aggregation of the data results in the loss of some information. The payout decisions

are managerial decisions made at the firm level and are based on the manager’s information

set. At the aggregate level, some firms might make a payout in a given month and others

might not make a payout. This information is lost by simply aggregating all payouts in the

month into a single number. However, at an individual firm level, repurchase activity is not

really a regular event so that it makes time-series analyses almost impossible. We have to

exercise a caution in interpreting our empirical results because we are using aggregated series.19While a unit root in earnings, Yt, is not rejected by the augmented Dickey–Fuller test with

lags more than three, it still appears to be stationary by the Phillip–Perron test.20Whereas conventional unit root tests use the null hypothesis of unit root, I(1), process, the

Kwiatkowski–Phillips–Schmidt–Shin unit root test uses the null hypothesis of stationarity,

either around a level or around a linear trend, and it allows for error autocorrelations. When

we implement the Kwiatkowski–Phillips–Schmidt–Shin (1992) unit root test, we find that Y,

D, and P are I(1) processes, whereas RP (RP ⁄ Y), and (P ⁄ Y) series are I(0) processes.

I. Ha et al.


Tab

le1

Un

itro

ot

test

s:Sa

mp

lep

erio

d,

1992

:1–

2010

:4

(i)

Au

gmen

ted

Dic

key–

Fu

ller

regr

essi

on

Dx t¼

a 0þ

axt�

1þPm i¼

1

c iD

x t�

iþ

v t;

(ii)

Ph

illi

ps–

Per

ron

regr

essi

on

x t=

b 0+

bxt)

1+

v t.

Yt

isea

rnin

gsse

ries

,D

tis

div

iden

dse

ries

,P

tis

sto

ckp

rice

seri

es,

RP

tis

shar

ere

pu

rch

ase

seri

es.

(D⁄Y

) tis

div

iden

dp

ayo

ut

seri

es,

(P⁄Y

) tis

PE

rati

ose

ries

,an

d(R

P⁄Y

) tis

shar

ere

pu

rch

ase

pay

ou

tra

tio

seri

es.

BD

tis

bro

add

ivid

end

seri

es(=

Dt

+R

Pt)

.B

DE

tis

bro

add

ivid

end

pay

ou

tse

ries

(=(D

⁄Y) t

+(R

P⁄Y

) t).

BD

Dt

isd

efin

edas

DD

t+

RP

t.T

hes

eva

riab

les

are

all

mo

nth

lyo

bse

rvat

ion

sfo

rth

esa

mp

lep

erio

do

f19

92:3

–20

10:4

,w

ith

219

ob

serv

atio

ns.

Cri

tica

lva

lues

of

t-st

atis

tics

for

bo

ths a

and

Z(t

b)

are:

10%

,)

2.57

7;5%

,)

2.88

1;1%

,)

3.47

5(F

ull

er,

1976

,ta

ble

s8.

5.1

and

8.5.

2).

Th

ed

etai

lso

fth

ead

just

edt-

stat

isti

csZ

(tb)

can

be

fou

nd

inth

ew

ork

of

Ph

illi

ps

and

Per

ron

(198

8).

Var

iab

les

(xt)

Dic

key–

Fu

ller

test

Ph

illi

ps–

Per

ron

test

s aZ

(tb)

1la

g2

lags

3la

gs4

lags

5la

gs6

lags

1la

g2

lags

3la

gs4

lags

5la

gs6

lags

Yt

)1.

742

)2.

036

)3.

069

)3.

651

)3.

57)

3.48

8)

1.82

2)

1.85

8)

1.97

2)

2.05

1)

2.11

4)

2.17

9

Dt

)1.

196

)1.

229

)1.

275

)1.

349

)1.

466

)1.

533

)1.

353

)1.

348

)1.

345

)1.

368

)1.

4)

1.42

2

RP

t)

6.58

9)

4.76

8)

3.94

2)

3.37

6)

3.10

1)

2.60

1)

8.74

1)

8.70

4)

8.84

6)

9.04

2)

9.26

8)

9.47

1

Pt

)1.

722

)1.

674

)1.

771

)1.

833

)1.

94)

1.93

2)

1.67

2)

1.66

5)

1.67

4)

1.69

3)

1.71

7)

1.73

2

(D⁄Y

) t)

3.26

)3.

458

)5.

502

)4.

406

)6.

046

)3.

656

)3.

078

)3.

182

)3.

424

)3.

524

)3.

612

)3.

625

(P⁄Y

) t)

3.38

8)

3.83

4)

6.40

3)

5.16

4)

6.33

8)

4.03

)3.

143

)3.

295

)3.

561

)3.

684

)3.

773

)3.

782

(RP

⁄Y) t

)9.

486

)5.

183

)4.

062

)2.

721

)3.

843

)3.

033

)11

.665

)11

.57

)11

.684

)11

.847

)12

.086

)12

.222

(BD

) t)

5.62

1)

4.03

6)

3.31

)2.

843

)2.

647

)2.

229

)7.

494

)7.

41)

7.54

)7.

739

)7.

976

)8.

178

(BD

E) t

)5.

621

)3.

079

)3.

001

)2.

654

)5.

714

)5.

653

)7.

241

)7.

016

)7.

272

)7.

501

)7.

818

)7.

968

(BD

D) t

)6.

603

)4.

804

)3.

921

)3.

374

)3.

06)

2.62

2)

8.73

2)

8.69

3)

8.82

7)

9.02

3)

9.25

3)

9.45



5. Empirical Results

5.1. Signaling Hypothesis

Our preliminary tests show that earnings and dividends each contain a unit root by

various unit root tests and they are cointegrated. However, their ratios are stationary,

as shown in Table 1. Hence, we employ a dividend payout ratio, D ⁄ Y, a share repur-

chase payout ratio, RP ⁄ Y, and earnings changes, DY, with three lags. We choose the

lag length considering both the Akaike (1974) and Schwarz (1978) criteria.

We present the test results in Table 2. The Sims test result based on equation (8)

shows that the null hypothesis that the future cj coefficients (i.e. j = )1, )2, and )3)

are all zero is not rejected for share repurchases (significance level = 0.306) (Panel

A). However, the same null hypothesis in equation (8¢) is rejected even at the 1% sig-

nificance level for dividends (significance level = 0.000) (Panel B). This finding

implies that dividends Granger-cause earnings but share repurchases do not. This

indicates that dividends contain additional information about future earnings (or

cash flows) that is not contained in past earnings, whereas share repurchases do not.

The former finding is not consistent with those of DeAngelo et al. (1996) and Ben-

artzi et al. (1997), but is consistent with the more recent findings of, among others,

Nissim and Ziv (2001) and Lee and Yan (2003). The latter finding is in line with

those of Lie and McConnell (1998) and Grullon and Michaely (2004).21

In Table 2, we also report the test results of the null hypothesis that the sum of

future coefficients is zero. In Panels A and B, the sum is positive. However, the

positive sum is not significant at the 5% level for share repurchases but is signifi-

cant at the 1% level for dividends, which suggests a stronger positive signaling of

future cash flows by dividends.

5.2. Undervaluation Hypothesis

As discussed in Section 3.3, we identify and derive the non-fundamental component

of the PE ratios by ðP=YÞnft ¼ C33ðLÞenf

3t , and that of the market prices by

Pnft ¼ Yt � C33ðLÞenf

3t . Then we relate the non-fundamental components to share

repurchases and dividends. Because we found (above) that dividends are informa-

tive payouts, using informative dividends in the trivariate model (equation 9) allows

us to identify undervaluation and overvaluation (see Section 3.3.1).

Before we report the test results, we present in Figure 1 the plot of S&P stock

prices and the undervaluation and overvaluation we calculated based on our trivari-

ate model, ðYt � C33ðLÞenf3t Þ, and four-variable models, ðYt � C44ðLÞenf

3t Þ. We find that

the extent of the undervaluation or overvaluation tends to be similar between the

trivariate and four-variable models, while the latter includes interest rates as an

additional variable in the model. The S&P index was very high in April 2000, at

1505.97, with an overvaluation of 101.27 based on the trivariate model and 71.03

21To the extent that share repurchase activity in recent years has to do with employee stock

option plans, the repurchase might not be information related.

I. Ha et al.


based on the four-variable model. It was again very high in October 2007 at

1547.04, but with an undervaluation of )41.21 based on the trivariate model and

)13.77 based on the four-variable model.

When stock market prices were increasing in the late 1990s, the overvaluation

tended to be high, too. However, when the stock market prices were declining after

2000, the overvaluation remained quite high. Similarly, when the market prices were

declining after 2008, the overvaluation remained relatively high.

We present the test results in Table 3. Again, we choose the lag and lead length

considering both the Akaike (1974) and Schwarz (1978) criteria. In Panel A, we

report the test result using share repurchases. In the share repurchase regression,

the sum of the three (two) lagged and lead coefficients on the non-fundamental

component of the PE ratios ðP=YÞnft ¼ C33ðLÞenf

3t is )0.443 ()0.372), with a t-statis-

tic of )3.390 ()2.943) and a significance level of 0.001 (0.003). This implies that

Table 2 Tests of the signaling hypothesis using Sims (1972) causality tests

This table shows that share repurchases do not Granger-cause future earnings, whereas dividends Gran-

ger-cause future earnings based on Sims two-sided regression-based causality tests. DYt is the change in

earnings, (RP ⁄ Y)t is share repurchase payout ratio, (D ⁄ Y)t is dividend payout series, and ((RP + D)t ⁄ Y)t

is broad dividend payout. These variables are all monthly observations for the sample period of 1992:2–

2010:4.

H0 (null hypothesis) v2-statistic

H0 (null hypothesis) sum of coefficient t-statistic Significance level

Sims (1972) causality test for sample period, 1992:2–2010:4

Panel A: Share repurchases

ðRP=YÞt ¼ aþPm

j¼�m

cjDYt�j, (8)

H0: cj = 0 for j = )1, )2, )3, v2(3) = 3.615 0.306

H0:P�3

j¼�1

cj ¼ 0 0.070 t = 1.814 0.070

Panel B: Dividends

ðD=YÞt ¼ aþPm

j¼�m

cjDYt�j (8¢)

H0: cj = 0 for j = )1, )2, )3, v2(3) = 46.063 0.000

H0:P�3

j¼�1

cj ¼ 0 0.163 t = 5.579 0.000

Panel C: Broad dividends (= share repurchases + dividends)

ððRP þ DÞt=YÞt ¼ aþPm

j¼�m

cjDYt�j, (8¢¢)

H0: cj = 0 for j = )1, )2, )3, v2(3) = 18.380 0.000

H0:P�3

j¼�1

cj ¼ 0 0.232 t = 4.065 0.000



share repurchases are significantly related to undervaluation. When we use the non-

fundamental component of the stock market prices, Pnft ¼ Yt � C33ðLÞenf

3t , we obtain

a similar result: the sum of the three (two) lagged and lead coefficients on the non-

fundamental component of the prices is )0.056 ()0.059) with a t-statistic of )3.701

()3.458) and a significance level of 0.000 (0.001), which indicates that share repur-

chases are significantly related to undervaluation at a 1% significance level.

In Panel B, we report the test result using dividends. In the dividend regression,

the sum of the three (two) lagged and lead coefficients on the non-fundamental

component of the PE ratios ðP=YÞnft ¼ C33ðLÞenf

3t is )0.023 (0.006), with a t-statistic

of )3.288 (0.840) and a significance level of 0.001 (0.401). This indicates that

dividends’ relation to undervaluation is quite mixed.22 Similarly, the sum of the

three (two) lagged and lead coefficients on the non-fundamental component of

prices, Pnft ¼ Yt � C33ðLÞenf

3t , is )0.000 ()0.000), with a t-statistic of )0.827 ()0.095)

and a significance level of 0.408 (0.924), which indicates that dividends are not sig-

nificantly related to undervaluation.

Overall, Panels A and B of Table 3 show that share repurchases are significantly

related to the undervaluation in both PE ratios and market prices, whereas

dividends are not. This finding is consistent with Stephens and Weisbach (1998),

Dittmar (2000), and the survey result of Baker et al. (2003) and Brav et al. (2005).

Dittmar (2000) finds that throughout her sample period, firms repurchase stocks to

take advantage of potential undervaluation. Our finding seems compatible with the

theoretical prediction by Ofer and Thakor (1987) in that a firm with large underval-

uation will use a share repurchase to reveal this information.

–1000

–500

0

500

1000

1500

2000

92-04 94-04 96-04 98-04 00-04 02-04 04-04 06-04 08-04

Date

S&P

sto

ck p

rice

(Ser

ies

1)

–600

–400

–200

0

200

400

600

S&P

sto

ck p

rice

(Ser

ies

2 an

d 3)Series 1

Series 2Series 3

Figure 1 S&P stock price (series 1) and undervaluation ⁄ overvaluation based on trivariate

(series 2) and four-variable (series 3) models.

22This suggests that while dividends might not be related to undervaluation in a short-hori-

zon, they might be related to undervaluation in a long horizon.

I. Ha et al.


Table 3 Tests of the undervaluation hypothesis: Sample period, 1992:2–2010:4

This table shows that share repurchases are related to the undervaluation, whereas dividends are not.

This result is robust regardless of whether we measure the undervaluation using PE ratios or market

prices based on the trivariate model of Zt = [DYt, Dt ⁄ Yt, Pt ⁄ Yt]¢. DDtis the change in dividends, RPt is

share repurchase series, ðP=YÞnft is the non-fundamental component of the PE ratio, and P

nft is the non-

fundamental component of stock price. These variables are all monthly observations for the sample

period of 1992:2–2010:4.

H0 (null hypothesis)

Value

(sum of coefficients) t-statistic SE

Significance

level


(a) Using non-fundamental components of PE ratio: RPt ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.372 )2.943 0.126 0.003

H0:P3

j¼�3

cj ¼ 0: )0.443 )3.390 0.131 0.001

(b) Using non-fundamental components of prices: RPt ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.059 )3.458 0.017 0.001

H0:P3

j¼�3

cj ¼ 0: )0.056 )3.701 0.015 0.000

Panel B: Dividends

(a) Using non-fundamental components of PE ratio: DDt ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: 0.006 0.840 0.007 0.401

H0:P3

j¼�3

cj ¼ 0: )0.023 )3.288 0.007 0.001

(b) Using non-fundamental components of prices: DDt ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.000 )0.095 0.001 0.924

H0:P3

j¼�3

cj ¼ 0: )0.000 )0.827 0.000 0.408


(a) Using non-fundamental components of PE ratio: ðRPt þ DtÞ ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.388 )2.734 0.142 0.006

H0:P3

j¼�3

cj ¼ 0:)0.481 )3.347 0.144 0.001



6. Further Analysis

6.1. Alternative Measure of Undervaluation based on Four-Variable Model

As an alternative to the trivariate model in Section 3.3, which we use to identify

undervaluation, here we consider a four-variable model by adding the interest rate.

Usually valuation requires a measure of cash flows (i.e. numerator component) and

a measure of the discount factor (i.e. denominator component). By adding interest

rate as a proxy for a time-varying discount rate, we consider a 4 · 1 vector, Z2t,

consisting of the first differenced earnings (DYt), dividend payout ratio (Dt ⁄ Yt),

interest rate (rt), and the PE ratio (Pt ⁄ Yt): Z2t = [DYt, Dt ⁄ Yt, rt, Pt ⁄ Yt]¢, which has

the following four-variable moving average representation (MAR):

Z2t ¼ ½DYt ;Dt=Yt ; rt ;Pt=Yt �0 ¼ CðLÞet ;

where et is a 4 · 1 vector consisting of ey1t ,e

d2t ,e

r3t , and e

nf4t ;e

y1t = earnings shock;

ed2t = dividend shock; er

3t = interest rate shock; enf4t = non-fundamental shock;

CðLÞ ¼ ½P

k ckijL

k� for i, j = 1, 2, 3, and 4, is a polynomial in the lag operator L; and

the disturbances (innovations) are orthonormalized such that var(et) = I. Again,

because we find above that dividends are informative payouts, using the informative

dividends in the four-variable model allows us to identify undervaluation and over-

valuation as in the trivariate model.

Table 3 (Continued)


Value


Significance

level

(b) Using non-fundamental components of prices: ðRPt þ DtÞ ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.071 )3.740 0.019 0.000

H0:P3

j¼�3

cj ¼ 0: )0.072 )4.231 0.017 0.000

Panel D: Broad dividends (= share repurchases + Ddividends)

(a) Using non-fundamental components of PE ratio: ðRPt þ DDtÞ ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.366 )2.837 0.129 0.005

H0:P3

j¼�3

cj ¼ 0: )0.466 )3.478 0.134 0.001

(b) Using non-fundamental components of prices: ðRPt þ DDtÞ ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.059 )3.415 0.017 0.001

H0:P3

j¼�3

cj ¼ 0: )0.057 )3.701 0.015 0.000

I. Ha et al.


Proposition 3. In the above four-variable moving average representation (MAR),

fundamental and non-fundamental shocks to (or components of) the PE ratios are

characterized by the following restrictions on Z2t:

C12ðLÞ ¼ C13ðLÞ ¼ C14ðLÞ ¼ C23ðLÞ ¼ C24ðLÞ ¼ C34ðLÞ ¼ 0

½or ck12 ¼ ck

13 ¼ ck14 ¼ ck

23 ¼ ck24 ¼ ck

34 ¼ 0; for all k�:

Once we identify the fundamental and non-fundamental shocks to (or components

of) the PE ratios, the non-fundamental components of the PE ratios and the market

prices are identified by ½C44ðLÞenf4t � and ½Yt � C44ðLÞenf

4t �, respectively.

Using a procedure similar to that in Section 5.2, we test whether share repur-

chases and dividends are related to our measure of undervaluation based on the

above four-variable model. We present the regression results in Panels A and B of

Table 4. In the share repurchase regression in Panel A, the sum of the three (two)

lagged and lead coefficients of the non-fundamental component of the PE ratios

ðP=YÞnft ¼ C44ðLÞenf

4t is )0.475 ()0.428), with a t-statistic of )3.525 ()3.060) and a

significance level of 0.000 (0.002). This indicates that share repurchases are signifi-

cantly related to undervaluation. When we use the non-fundamental component of

the stock market prices, Pnft ¼ Yt � C44ðLÞenf

4t , we obtain a similar result: the sum

of the three (two) lagged and lead coefficients on the non-fundamental component

of the prices Pnft is )0.062 ()0.067), with a t-statistic of )4.121 ()3.883) and a

significance level of 0.000 (0.000), which indicates that share repurchases are signifi-

cantly related to undervaluation.

In the dividend regression in Panel B, the sum of the three (two) lagged and lead

coefficients on the non-fundamental component of the PE ratios is )0.023 (0.005),

with a t-statistic of )3.239 (0.743) and a significance level of 0.001 (0.458). This indi-

cates that the dividends’ relation to undervaluation is mixed, as in the case of Panel B

of Table 3. This suggests that dividends might not be related to undervaluation in a

short horizon, but they might be related to undervaluation in a long horizon. Simi-

larly, the sum of the three (two) lagged and lead coefficients of the non-fundamental

component of prices is )0.001 ()0.000), with a t-statistic of )1.211 ()0.308) and a

significance level of 0.226 (0.758), which indicates that dividends are not significantly

related to undervaluation. Overall, Panels A and B of Table 4 show that share repur-

chases are significantly related to the undervaluation of both PE ratios and market

prices, whereas dividend changes are not related to the undervaluation at all when we

use a four-variable model including the interest rate.

6.2. Broad Dividends in lieu of Narrow Dividends

6.2.1. Background

Given that information about future cash flows should be closely related to current

underpricing, it seems odd to find that conventional dividends and share repur-

chases are signaling through different routes. How do we understand this puzzling

observation? Here, we conjecture that this puzzle is related to the debate on using a



Table 4 Tests of the undervaluation hypothesis using 3-month T-bill rates: 1992:4 – 2010:4

This panel shows that share repurchases are related to undervaluation, whereas dividends are not. This

result is robust whether we measure the undervaluation using PE ratios or market prices based on the four

variable model of Zt = [DYt, Dt ⁄ Yt, rt, Pt ⁄ Yt]¢. DDt is the change in dividends, RPt is share repurchase

series, ðP=YÞnft is the non-fundamental component of the PE ratio, P

nft is the non-fundamental compo-

nent of stock price. These variables are all monthly observations for the sample period of 1992:2–2010:4.


Value


Significance

level


(a) Using non-fundamental components of PE ratio: RPt ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.428 )3.060 0.140 0.002

H0:P3

j¼�3

cj ¼ 0: )0.475 )3.525 0.135 0.000

(b) Using non-fundamental components of prices: RPt ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.067 )3.883 0.017 0.000

H0:P3

j¼�3

cj ¼ 0: )0.062 )4.121 0.015 0.000

Panel B: Dividends

(a) Using non-fundamental components of PE ratio: DDt ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: 0.005 0.743 0.006 0.458

H0:P3

j¼�3

cj ¼ 0: )0.023 )3.239 0.007 0.001

(b) Using non-fundamental components of prices: DDt ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.000 )0.308 0.001 0.758

H0:P3

j¼�3

cj ¼ 0: )0.001 )1.211 0.001 0.226


(a) Using non-fundamental components of PE ratio: ðRPt þ DtÞ ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.449 )2.823 0.159 0.005

H0:P3

j¼�3

cj ¼ 0:)0.522 )3.483 0.150 0.000

I. Ha et al.


broad definition of dividends that includes both narrow conventional cash divi-

dends and share repurchases.

Traditionally, stock price fluctuations are explained by changes in the expected

present value of future dividends (i.e. the dividend discount model [DDM]). How-

ever, several studies provide evidence that stock price fluctuations are too large to

result solely from changes in the expected present discounted value of dividends

(e.g. LeRoy and Porter, 1981; Shiller, 1981; Campbell and Shiller, 1987; West, 1988;

Gilles and LeRoy, 1991; Fama and French, 1993). Given the failure of the DDM to

explain stock price fluctuations, researchers have pursued alternative models of

stock valuation. Some researchers introduce behavioral finance models (e.g. Cutler

et al., 1990; Delong et al., 1990; Barberis et al., 1998; Daniel et al., 1998; Odean,

1998).

In the accounting literature, an alternative valuation model, the residual income

model (RIM), has become popular recently primarily due to its formalization by

Ohlson (1991, 1995) and Feltham and Ohlson (1995) (see also Lee, 1999). The RIM

assumes an accounting identity, the clean surplus relation, which posits that the

change in book value of equity is equal to the difference between accounting earn-

ings and dividends. The residual income (or abnormal earnings) is defined as

the difference between accounting earnings and the previous period book value

Table 4 (Continued)


Value

(sum of coefficients) t-Statistic SE

Significance

level

(b) Using non-fundamental components of prices: ðRPt þ DtÞ ¼ aþP3

j¼�3

cjPnftgrave;‘j

H0:P2

j¼�2

cj ¼ 0: )0.080 )4.152 0.019 0.000

H0:P3

j¼�3

cj ¼ 0: )0.078 )4.697 0.017 0.000

Panel D: Broad dividends (= share repurchases + Ddividends)

(a) Using non-fundamental components of PE ratio: ðRPt þ DDtÞ ¼ aþP3

j¼�3

cjðP=YÞnft�j

H0:P2

j¼�2

cj ¼ 0: )0.424 )2.981 0.142 0.003

H0:P3

j¼�3

cj ¼ 0: )0.498 )3.608 0.138 0.000

(b) Using non-fundamental components of prices: ðRPt þ DDtÞ ¼ aþP3

j¼�3

cjPnft�j

H0:P2

j¼�2

cj ¼ 0: )0.068 )3.846 0.018 0.000

H0:P3

j¼�3

cj ¼ 0: )0.063 )4.121 0.015 0.000



multiplied by the cost of equity. The RIM maintains that the current stock price

equals the current book value of equity plus the present discounted value of the

expected future residual income.

A very important implication of the RIM is that dividends, by way of the clean

surplus relation, are defined broadly as the difference between earnings and the

change in book value. Therefore, dividends in the RIM include not only conven-

tional cash dividends but also other forms of cash payouts to shareholders (e.g.

share repurchases, acquisitions) (see also Boudoukh et al., 2007). It is interesting to

note that most previous studies of the DDM and dividend models use narrow cash

dividends.23

6.6.2. Empirical Results

To see whether the use of broad dividends makes a difference in the test of the two

types of signaling hypotheses, we use the same two-sided regression-based Sims cau-

sality test using broad dividends for the test of the cash flow signaling hypothesis:

ðBD=YÞt ¼ aþXm

j¼�m

cjDYt�j; ð800Þ

where (BD ⁄ Y)t = ((RP + D)t ⁄ Y)t. That is, the broad dividends include both conven-

tional narrow cash dividends and share repurchases. We report the test results in

Panel C of Table 2. We find that the null hypothesis in equation (8¢¢), H0: cj = 0 for

j = )1, )2, )3, is rejected at the conventional significance level of 10% for the broad

dividends (its significance level is 0.000). This finding implies that broad dividends

Granger-cause earnings as the narrow dividends do. In addition, the sum of future

coefficients, cj = 0 for j = )1, )2, )3, is 0.232 and significant (its significance level is

0.000). These findings indicate that broad dividends contain additional information

about future earnings (or cash flows) that is not contained in past earnings, whereas

share repurchases do not, and their increase signals an increase in future earnings.

Using a procedure similar to that in Section 5.2, we test whether broad divi-

dends are related to our measure of undervaluation. We present the regression

results in Panels C and D of Table 3. In Panel C, we define broad dividends as the

sum of share repurchases and narrow cash dividend levels, while in Panel D we

define broad dividends to include share repurchases and the changes in the narrow

23In the finance literature, Ackert and Smith (1993) use broad dividends that include share

repurchases for Canadian data. TeSelle (1998) uses simulations by using parameters obtained

from the data of Ackert and Smith (1993). TeSelle (1998) argues that the DDM is not

rejected by variance-bounds tests when broad dividends are used probably because of the lack

of power in broad-dividend tests. He defines broad dividends as including cash (narrow) div-

idends and proceeds from share liquidations. Boudoukh et al. (2007) find the importance of

using a broad measure of payouts including repurchases in predicting both the time series

and cross-section of equity returns (see also Robertson and Wright, 2006). In the accounting

literature, most studies of DDM use narrow dividends (e.g. Frankel et al., 1998; Dechow

et al., 1999; Lee et al., 1999; Francis et al., 2000). However, Penman and Sougiannis (1998) use

a broad dividend that includes repurchases and cash and ⁄ or non-cash terminal distributions.

I. Ha et al.


cash dividends. In the broad dividend regression in Panel C, the sum of the three

(two) lagged and lead coefficients on the non-fundamental component of the PE

ratios is )0.481 ()0.388), with a t-statistic of )3.347 ()2.734) and a significance

level of 0.001 (0.006). This indicates that the broad dividends are significantly

related to undervaluation. Similarly, the sum of the three (two) lagged and lead

coefficients of the non-fundamental component of prices is )0.072 ()0.0071), with

a t-statistic of )4.231 ()3.740) and a significance level of 0.000 (0.000), indicating

that the broad dividends are significantly related to undervaluation.

In the broad dividend regression in Panel D of Table 3, the sum of the three



level of 0.001 (0.005), which indicates that the broad dividends are significantly


coefficients of the non-fundamental component of prices is )0.057 ()0.059), with a

t-statistic of )3.701 ()3.415) and a significance level of 0.000 (0.001), showing that

the broad dividends are significantly related to undervaluation.

In Panels C and D of Table 4, we test whether broad dividends are related to

our measure of undervaluation based on the four-variable model including a

measure of the discount rate. In Panel C, we define broad dividends as the sum of

share repurchases and narrow cash dividend levels, while in Panel D we define

broad dividends to include share repurchases and the changes in narrow cash divi-

dends. In the broad dividend regression in Panel C of Table 4, the sum of the three



level of 0.000 (0.005), which indicates that the broad dividends are significantly


coefficients of the non-fundamental component of prices is )0.078 ()0.080), with a

t-statistic of )4.697 ()4.152) and a significance level of 0.000 (0.000).

In the broad dividend regression in Panel D, the sum of the three (two) lagged

and lead coefficients on the non-fundamental component of the PE ratios is )0.498

()0.424), with a t-statistic of )3.608 ()2.981) and a significance level of 0.000

(0.003), which indicates that the broad dividends are significantly related to under-

valuation. Similarly, the sum of the three (two) lagged and lead coefficients of the

non-fundamental component of prices is )0.063 ()0.068), with a t-statistic of

)4.121 ()3.846) and a significance level of 0.000 (0.000).

Overall, in Panels C and D of Tables 3 and 4, we find that broad dividends,

whether they include narrow cash dividends or their changes as well as share repur-

chases, are significantly related to the undervaluation in both PE ratios and market

prices, whether we use a trivariate model or a four-variable model. This is in con-

trast to the findings in Panel B of Tables 3 and 4, where narrow cash dividend

changes are not related to undervaluation at all.

More importantly, the findings of broad dividends’ undervaluation signaling

(Panels C and D of Table 3) are strongly consistent with the finding of broad



dividends’ cash flow signaling (Panel C of Table 2). These findings help us to

resolve the puzzling behavior of narrow cash dividends and share repurchases in the

context of the two types of signaling hypotheses.

7. Summary and Concluding Remarks

Previous studies show that share repurchases are primarily associated with the

signaling of the current undervaluation, whereas dividends are mainly associated

with the signaling of future cash flows to outside investors. However, in general, we

expect that the signaling of the current undervaluation should be closely related to

the signaling of future cash flows. Hence, the findings in previous studies of

different signaling by share repurchases and dividends seem puzzling.

Using a time-series identification of undervaluation and future cash flow

signaling based on the information asymmetry between inside managers and outside

investors, we confirm the previous findings. Then, using broad dividends defined to

include both cash dividends and share repurchases, we find that the broad dividends

are related to both the signaling of future cash flows and the signaling of the

current undervaluation.

One way to understand these findings would be to note that between the two

means of signaling management optimism about a firm’s prospects to the market,

managers tend to use dividends to pay out permanent earnings and repurchases

to pay out temporary earnings (e.g. Guay and Harford, 2000; Jagannathan et al.,

2000; Lee and Rui, 2007). Because, by nature, permanent earnings are inclined to

be persistent and temporary earnings tend to be non-persistent, dividends tend to

better predict future earnings compared to share repurchases. If the market is fully

efficient, the stock market price should reflect a fair value without any undervalu-

ation and overvaluation. In reality, the market price might not always reflect the

fair value for some reason, but this should still be a temporary phenomenon,24

which is more likely related to share repurchases that are associated with paying

out temporary earnings (see also Hertzel and Jain, 1991).

More importantly, our findings that broad dividends are related to both future

cash flows and current undervaluation suggest that managers use broad dividends

to pay out firms’ cash flows rather than focusing on or distinguishing between

narrow cash dividends and share repurchases, and investors are mainly interested in

broad dividend payouts rather than the choice between narrow dividends and share

24In the dividend regression in Panel B of Table 3 (Table 4), we observe that the sum of the

three lagged and lead coefficients on the non-fundamental component of the PE ratios is sig-

nificant, while the sum of the two lagged and lead coefficients is not significant. One inter-

pretation of this finding is that while dividends might not be related to undervaluation in a

short horizon, they might be related to undervaluation in a long horizon (see footnote 20).

I. Ha et al.


repurchases so they fully understand the equivalence of the two types of signaling

based on the broad dividends.

This view is consistent with recent survey findings by Brav et al. (2005) that

repurchases are thought to convey at least as much information as dividends

although repurchases are very flexible and executives believe that institutions are

indifferent between dividends and repurchases. They find that almost every

executive they interviewed responded that dividend payout and share repurchases

convey management’s confidence about the future. This interpretation is consistent

with previous studies that use various variance tests of the dividend discount model:

when broad dividends include share repurchases, the market appears to be more

efficient than when they use narrow dividends. Overall, our findings indicate that

we should seriously consider using a broad definition of dividends in future

studies.25

Boudoukh et al. (2007) investigate the empirical implications of using various

measures of payout yield rather than dividend yield for asset pricing models. They

find that once repurchases are accounted for, measures of total payout yield show

significant predictive ability in both the time series and cross-section of equity

returns (see also Robertson and Wright, 2006). Their finding is also consistent with

our finding and is also more in line with an economically meaningful measure of

corporate cash flows to shareholders (e.g. Miller and Modigliani, 1961; Sethi, 1996,

2009).26

If we take the agency cost perspective, it might be easier to understand the

importance of a broad dividend. In general, the agency theory (or the free cash flow

theory) does not distinguish between the use of dividends and repurchases to miti-

gate agency costs. Any form of distribution of excess cash to shareholders helps to

reduce agency costs. Although dividend payout is a pre-commitment device and

share repurchases are ex-post adjustments to the payout policy, the difference in their

signaling role seems inconsequential. In this sense, dividends and repurchases are

complementing each other and total payout might be the more important variable.

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Appendix

Proof of Proposition 2 and the implementation of identifying restrictions on funda-

mental and non-fundamental components of the PE ratios:

Consider the trivariate vector autoregression (VAR) of Z1t = [DYt, Dt ⁄ Yt, Pt ⁄ Yt]¢

Z1t ¼ AðLÞZ1t�1 þ ut ; ðA1Þ

where

AðLÞ ¼ ½AijðLÞ� ¼X1

k¼1ak

ijLk�1

h i; for i; j ¼ 1; 2; and 3; ðA2Þ

ut = [u1t, u2t, u3t]¢ = Z1t ) E(Z1t|Z1t)s, s > 1) with var(ut) = W = [rij] for i, j = 1,

2, and 3. That is, ut is a non-orthonormalized innovation in Z1t. By estimating this

trivariate VAR, we obtain estimates of A(L) and W.

By inverting this trivariate VAR of Z1t, we obtain a trivariate moving average

representations of Z1t:

I. Ha et al.


Z1t ¼ ½I � AðLÞL��1ut ; ðA3Þ

where I is the identity matrix of rank 3.

By comparing the trivariate moving average representations in equation (9),

Z1t = C(L)et, with that in equation (A3), estimates of the moving average represen-

tations coefficients, C(L), can be obtained as follows. Note that:

C0et ¼ ut and ðA4Þ

Z1t ¼ CðLÞet ¼ ½I � AðLÞL��1ut ; ðA5Þ

where C0 ¼ ½ckij� with k = 0. Using equation (A4), equation (A5) implies that:

CðLÞ ¼ ½I � AðLÞL��1C0: ðA6Þ

This implies that, given an estimate of A(L), we only need an estimate of C0 to

calculate C(L). This can be obtained by taking the variance of each side of (A4):

c011 c0

12 c013

c021 c0

22 c023

c031 c0

32 c033

24

35 c0

11 c021 c0

31

c012 c0

22 c032

c013 c0

23 c033

24

35 ¼ r11 : :

r21 r22 :r31 r32 r33

24

35:

C0C00 ¼ X ¼ ½rij�; for i; j ¼ 1; 2; and 3: ðA7Þ

In the trivariate model of Z1t, we obtain six restrictions (equations) for the nine

elements of C0. Hence, we need at least three additional restrictions to just identify the

nine elements of C0. Our trivariate models of Z1t with restrictions in equation (10)

(i.e. C12(L) = C13(L) = C23(L) = 0, or ck12 ¼ ck

13 ¼ ck23 ¼ 0, for all k) provide at least

three restrictions for the identification (e.g. c012 ¼ c0

13 ¼ c023 ¼ 0).



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Information Content of Dividends and Share Repurchases*