This document summarizes a 1964 study by Irwin Friend and Marshall Puckett examining the relationship between stock prices, dividends, and retained earnings. The study finds that in growth industries, retained earnings have a relatively greater impact on stock prices than in non-growth industries. It also finds that the customary view that dividends have a stronger effect than retained earnings is invalid, as the results varied across industries and years. The study concludes there is little basis for believing dividends universally have a stronger impact than retained earnings, and that the appropriate payout ratio depends on firm-specific factors like profitability and risk.

1. Seminar in Finance Course Code: 622
Synopsis on: Dividends and Stock Prices
By Irwin Friend and Marshall Puckett, University of Pennsylvania
Submitted by: Sudarshan Kadariya, Roll No. 04/2010, M. Phil in Management.
Citation:
Friend, I. and Puckett, M. (1964). Dividends and stock prices. American Economic Review, September, pp. 656-682.
Purpose: To discuss the limitations of the previous findings, describe various approaches to avoiding those limitations,
and present new results that seem more in accord with theoretical preconceptions.
Motivation: The review of existing literature provides controversy and confusion over the relative importance of
dividends and retained earnings in determining the price-earnings ratios of common stocks. The statistical studies
purport that the strong market preference for dividends but are questionable.
Theoretical & Empirical conclusions:
The relative prices of the stock at given point of time are determined by suitable discounting of expected future
returns. The future returns constitutes dividend income or capital gains, assuming rational behavior and should
be estimated on an after tax basis, and assuming that a higher average tax applicable to dividend income than
to capital gains.
The influence of retained earnings on share prices should be the function of the profitability of the corporate
investment opportunities, in view of the fact that external equity financing is generally not a completely
satisfactory substitute for internal financing. For instance, when the corporate profit exceeds the market rate of
return, price should increase as the proportion of retained earnings increases.
When stock prices are related to the current dividends and retained earnings, higher dividend payout is usually
associated with higher price earnings ratios.
A dollar of dividends has four times the average impact on share price as does a dollar of retained earnings,
Grahman and Dodd (1934) the “dividend effect.”
The recent empirical findings confirmed the existence of a strong dividend effect or, that the dividend
multiplier is still several times the retained earnings multiplier.
The theoretical and empirical conclusions reached to the fact that the market valuation of retained earnings is lower than
the dividends, and the lower valuation could exists if any one of the following situations exist; i) stockholders strong
preference for current income over future, ii) the expected increase in earnings arising from increased per share
investment is viewed as involving the much higher degree of risk than that attaching to earnings on existing corporate
assets, and iii) the profitability of incremental corporate investment, as viewed by shareholders is extremely low relative
to the competitive yield prevailing in the stock market.
Justification of the issue: Authors expect that for the average firm, irrespective of investor preference between
dividends and capital gains, payout policies are such that at the margin a dollar of retained earnings should be
approximately equal in market value of the dollar of dividends foregone. In support to the contrary position, they
outlined the considerable number of reasons why previous statistical studies yielded biased results. The comments are
outlined as: omitted variables - risk variable and externally financed growth rate, regression weights – extreme values
are much more important but the outliers are omitted in regression model, random variations in income - short-run
reporting of income and dividend payout influence bias, income measurement errors – diversity of accounting
procedures employed in business earning rise to measurement errors, and least-squares bias – assumes one way
causality between dividends and price, rather dual causality requires the use of a complete model, which are directed to
the following regression equation because most of the previous studies commonly used this regression equation to reach
their conclusions.
Pt = a + b Dit + c Rit + eit Where, per share price are regressed on dividends and retained earnings.
Modifications on the commonly used regression model were done in line with the outlined reasons as; the problem of
omitted variables managed by expanding the regression equation to include these variables as separate effects (Fi) on

2. price, introduced firm effects and the multiplicative relationship for the firm effects in regression model which curve the
regression weight biases, the problem of least-squares bias handled by specifying a complete model including a
dividend supply function as well as the customary price relation, by introducing the lagged price variable in the
regression model – the problem of random income movement is managed, market estimates for earning normalization is
used to meet the problem of short-run earnings movements and finally, the influence of dividend payout on stock price
subjected to time series analysis and its validity were checked.
Methodology: The statistical analysis worked out with five industry samples, viz. chemicals, electronics, electric
utilities, foods, and steels for the period 1956 and 1958. The sample period covered both the boomed and depressed
year in the economy. Both cyclical and noncyclical industries are covered, accessibility of data and resources
availability were also considered both in industry and year selection, for the heterogeneous industry mix – an attempt
was made to conform a fairly narrow definition of the industries and among the several years considered for analysis
only the period 1956 and 1958 was chosen due to its feasibility.
Major findings:
The usual linear relationship between average prices and dividends and retained earnings indicated that the
customary strong dividend and relatively weak retained earnings effect in three of five industries. This
relationship is for the comparison with alternative model. In another terms, in growth industries (chemical,
electronics and electric utilities) more weights relatively is given to retained earnings than in non-growth
industries (foods and steels) but the evidence is not uniform. (ref. table 1)
Holding the firms’ effects constant the regression results indicated that dividends have a predominant influence
on stock prices in the same three out of five industries but the difference between the dividends and retained
earnings coefficients are closer except steels industry in 1956. (ref. table 2)
The price effects on dividend supply are probably not a serious source of bias in the customary derivation of
dividend and retained earnings effects on stock price. (ref. table 3)
Short-run adjustment in prices to current level of income by introducing lagged price variable in regression
equation, it is indicated that retained earnings receive greater relative weight than dividends in the majority of
the cases. The exceptions are steels and foods in 1958. The results also showed that the undesirable properties
of negative dividend coefficients. (ref. table 4)
The normalized procedure on retained earnings which was based on the period 1950-61, and prices were then
related to dividends and normalized retained earnings for chemicals, foods and steels for 1956 and 1958,
indicated that the customary results (ref. table 5). When, the prior year’s normalized retained earnings-price
variable was added to hold the firm effects constant, the results also indicated that the same type of customary
results. (ref. table 6)
The more detailed analysis of chemical industry by omitting three firms because of the undue regression
weighting suggested that the results are changed substantially; the retained earnings become somewhat more
important than dividends as a price determinant. (ref. table 7)
Since, 12 out of 20 cases the time-slope coefficients for the relative earnings yield and relative payout
regression have the same sign, while in eight cases they are opposite sign, which suggest that price-earnings
ratio may have some tendency to move inversely to the payout ratio in contrast to the customary assertion of a
direct relation and the correlation between two slope coefficients is not very high but significant. These are the
strong evidence that the customary results are invalid. (ref. table 8)
Conclusions: The study concluded that in the stock market there is little basis for the customary view that except for
unusual growth stocks (chemical industry), dividends has strong effect on stock price than the retained earnings. In non-
growth industries investor preferred dividends for stock valuation than retained earnings but the opposite may be true
for growth stocks. The study also raised the issue of optimal payout ratio for investors for various types of stocks with
different profitability of investment opportunities, risk, sources of financing, etc. or even in indicating whether an
optimal ratio exists which to some extent is independent of profit prospects.
Critical appraisal: The in depth analysis of commonly used regression model has provide us the in depth knowledge.
The study is considered a useful for researchers who want to pursue through the regression models. Similarly, it is very
much useful for early practitioners and academicians. On the other hand, weak points found in this article is major
conclusion is derived from very small sample (only 17 chemical companies) and overriding of regression bias (omitted
3 chemical firms) which was considered the weakness of previous studies. ***