Exploring the Relationship Between Risk-Adjusted Stock Returns and Dividend Yields
Abstract
This study examines the association between dividend yield and stock returns of firms listed on Karachi Stock Exchange (KSE), adjusting the returns for risk using the Capital Asset Pricing Model (CAPM) and Fama and French (1993) three factor model. This research study will provide useful contribution to the existing knowledge base and to ascertain whether investors demand high before tax returns against high dividend paying stocks. The current study explored the time series difference in average returns across stocks having different dividend yield. To determine whether the higher dividend yield paying firms produces high risk-adjusted returns, the sample data of 125 non-financial firms listed on Pakistan Stock Exchange - PSX are classified into five portfolios/quintiles ranking from low dividend yield firm to high dividend yield firms for the period spanning over 2003-2012. The stock returns are risk-adjusted using Fama and French (1993) three factor model. The findings of the study show that there exists a positive relationship between dividend yield and raw return, of five dividend yield sorted portfolios/quintiles. But the relationship does not persist between dividend yield and portfolio returns after adjusting returns for risk factors namely, market risk premium, size premium and value premium. Moreover, it is also found that among the PSX listed firms, large size firms are the highest dividend paying firms. Furthermore, out of the three risk factors applied; only market risk factor captures and explains most of the variation in dividend yield portfolio returns obtained, applying both CAPM and Fama and French three factor model. This finding indicates the presence of market risk factor for dividend paying firms as it is significant while applying both the models. In other words, the other two premiums (size and value premium) are not priced by the investors. Thus, the results are not showing any sign of tax-effect in PSX stock market implying that investors do not require higher returns against tax penalty on dividend.
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