Discussion—Reactions to Dividend Changes Conditional on Earnings Quality

Abstract

Corporate disclosures are an important source of information for investors. Many studies have documented strong price reactions to earnings, dividends, and other corporate announcements. For dividend announcements, the price implications appear straightforward: price is the present value of expected future dividends. Hence, to the extent that future dividends are related to current dividends, dividend changes should trigger price responses. Other corporate disclosures, such as earnings, may also be viewed as proxies for future dividends. The price reaction to a particular disclosure should increase in the difference between the implied equity value based on that disclosure and price prior to the disclosure. The magnitude of price reaction should also increase in the precision of the disclosure and decrease in the precision of all prior price-related information (see, e.g., Holthausen and Verrecchia [1988]). Mikhail, Walther, and Willis (2003, MWW) test this precision effect focusing on dividend disclosures and using “earnings quality” (the association between future cash flow and past earnings) as a proxy for the precision of prior information. In particular, MWW test whether the magnitude of price reactions to dividend change announcements is negatively related to earnings quality. They also use revisions in analysts’ earnings forecasts as an alternative proxy for the change in expected cash flows triggered by the dividend change announcement. For dividend increases, MWW find that the magnitudes of both price reactions and revisions in analysts’ earnings forecasts are negatively related to earnings quality. For dividend decreases, however, they find insignificant results. The hypothesis that MWW test is simple, intuitive, and well established in the analytical literature. Their focus on dividend change announcements is also justified. Analytically, dividends are linked directly to stock prices, and empirically, dividend changes appear to convey relevant information to investors, as is evident by the significant price reactions (e.g., Aharony and Swary [1980]; Asquith and Mullins [1983]) and by the change in expected future earnings (e.g., Ofer and Siegel [1987]; Nissim and Ziv [2001]). Therefore, the research question is relevant. As discussed below, however, I have some concerns regarding the analysis, pri-