Complementarity or Substitution: Time-Variant Implications of Dividends and Stock Repurchases – An Explorative Study

Abstract

Prior studies associate dividends with permanent earnings signals and stock repurchases with transitory earnings signals. In contrast, we provide empirical evidence that in recent decades, dividends and stock repurchases have converged to each other in terms of their signaling for future earnings. According to our explorative empirical analysis using a modified version of the Dechow et al. (2008) earnings persistence model, the relation between dividend and stock repurchase signals has changed from complementary to substitutive. However, cumulative abnormal returns following payout announcements indicate that the stock market is not fully aware of this convergence as cumulative abnormal returns in response to stock repurchases do not increase in conjunction with their changing signals. We also explore potential reasons for the documented convergence, and find that the declining signaling of dividends for future earnings may be driven by increased institutional ownership, reducing agency-problems between management and shareholders. Furthermore, the signaling of stock repurchases converges to that of dividends because the former are paid more persistently and are less related to transitory non-operating income. Our findings help investors and managers in allocating their assets more efficiently by improving their understanding of payout policy implications.