Article

Dividend Yields, Stock Returns, and Reputation

The relationship between dividend yields and stock returns is an unresolved issue in finance. Previous papers show mixed results on the relationship. In this paper, a reputation model of dividend is presented, and its implications on the relationship between dividend yields and stock returns are discussed. A stock with a short history of dividend payments has not yet established a reputation, so its signal, such as unexpected dividend increases, is not as reliable as the signal from a stock with a long history of consistent dividend payments. For old firms, the stock price adjusts fully to a new signal because of a reputation. On the other hand, the stock price of a young firm adjusts partially to a new signal because of some doubt on the credibility of the signal. As a result, if we have young firms in our sample mixed with old firms, it could distort the relationship between stock returns and dividend yields. Firms with a reputation tends to have less risk compared to firms without reputation, and the expected return will be lower given dividend yield, which is called ‘reputation effect’. We group stocks according to the existence of reputation and analyze the relationship between dividend yields and stock returns using quarterly yields and returns. As we expected, the reputation effect is strongest for established firms

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