Value relevance of earnings, book value and dividends in an emerging capital market: Kuwait evidence

Global Finance Journal 23 (2012) 221–234

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Value relevance of earnings, book value and dividends in an emerging capital market: Kuwait evidence Osama M. Al-Hares a,⁎, Naser M. AbuGhazaleh a, 1, Ayman E. Haddad b, 2 a b

College of Business Administration, Gulf University for Science and Technology (GUST), P.O. Box 7207, Hawally 32093, Kuwait College of Business and Economics, American University of Kuwait (AUK), P.O. Box 3323, Safat 13034, Kuwait

a r t i c l e

i n f o

Article history: Received 14 October 2011 Accepted 16 September 2012 Available online 13 October 2012 JEL classification: M40 M41 G14 Keywords: Gulf cooperation council (GCC) Market-based accounting research (MBAR) Value relevance

a b s t r a c t This study examines the value relevance of book value, earnings and dividends for a sample of all non-financial firms listed on the Kuwait Stock Exchange (KSE) over the period 2003–2009. After controlling for the impact of the global financial crisis, empirical results provide evidence on the value relevance of book value and earnings in the KSE. The results indicate that dividends are not a value-relevant in the presence of earnings in the valuation model. However, when dividends are used as a substitute for earnings they become value-relevant. The explanatory power of the model including both book value and earnings is almost indistinguishable from that of book value and dividends. Furthermore, splitting earnings into dividends declared (or paid) and earnings retained results in each of the two variables becoming value-relevant. The average dividend pay-out ratio tends to increase over time, indicating that dividend policies do matter in the KSE and that dividends in Kuwait are used to boost investors' confidence and support share price, noticeably during the global financial crisis period. © 2012 Elsevier Inc. All rights reserved.

1. Introduction Financial statements are considered the most important source of information for stakeholders. Investors use financial statements to evaluate the share price of a firm by using valuation models. The general purpose of valuation models is to assess the impact of accounting information on stock prices. The ability of accounting data to summarize information affecting equity value is usually measured by the explanatory power of regression analysis as measured by R2. Valuation models with higher R2s indicate the ability of accounting ⁎ Corresponding author. Tel.: +965 2530 7408. E-mail addresses: [email protected] (O.M. Al-Hares), [email protected] (N.M. AbuGhazaleh), [email protected] (A.E. Haddad). 1 Tel.: +965 2530 7431. 2 Tel.: +965 2224 8399. 1044-0283/$ – see front matter © 2012 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.gfj.2012.10.006

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data to explain the variations in stock prices. The value relevance of accounting information using crosssectional valuation models has a substantial history in accounting and other literatures. Market-based accounting research (MBAR) often chooses between price models and return models. In price models, stock prices are regressed against earnings per share, whereas in return models, returns are regressed on scaled earnings variables (Kothari & Zimmerman, 1995). Prior value-relevance research is primarily based on the price model suggested by Ohlson (1995) and its subsequent refinements (e.g., Feltham & Ohlson, 1995). This study assesses the value relevance of accounting information in explaining the variation in stock prices for firms listed on the KSE as an example of an emerging Gulf cooperation council (GCC) market. Using a sample of 667 firm-year observations, the study employs Ohlson's (1995) valuation equation to investigate the value-relevance of earnings, book value and dividends in Kuwait. After controlling for the impact of the global financial crisis, empirical results provide evidence on the value relevance of book value and earnings of Kuwaiti listed firms. Dividends are found to be insignificant in the presence of earnings in the valuation model. However, when dividends are substituted for earnings, the estimated coefficient of dividends becomes positive and significant. The explanatory power of the model including both book value and earnings is almost indistinguishable from that including book value and dividends. Furthermore, splitting earnings into dividends declared (or paid) and earnings retained results in each of the two variables becoming value-relevant. Results from estimating the annual cross-sections provide evidence consistent with prior research that the value relevance of accounting information (measured by R 2 values) in Kuwait has declined over time (e.g., Balachandran & Mohanram, 2011; Core, Guay, & Buskirk, 2003; Dontoh, Radhakrishnan, & Ronen, 2004; Elliott & Jacobsen, 1991; Entwistle & Phillips, 2003; Francis & Schipper, 1999; Lev & Zarowin, 1999; Ramesh & Thiagarajan, 1995). The results also indicate that the average dividend pay-out ratio tends to increase over the study period, indicating that dividend policies do matter in Kuwait and that dividends are used to boost investors' confidence and support share prices, noticeably during the global financial crisis period. Furthermore, the value relevance of accounting information is not driven by industry effects in the KSE. However, the information content of accounting information is significantly higher for large Kuwaiti firms compared to their small firm counterparts. This study contributes to the existing literature via examining the value relevance of accounting information and particularly dividends for firms listed on the KSE as an example of an emerging GCC market. Prior studies provide evidence on the value relevance of book value and earnings for Kuwaiti listed firms (e.g., Alfaraih & Alanezi, 2011; ElShamy & Al-Qenae, 2005), whereas the role of dividends in determining stock prices remains an empirical issue. In addition to examining the value relevance of earnings and book values, this study is the first to examine the value relevance of dividends utilizing Kuwaiti data. Furthermore, Al-Deehani and Al-Loughani (2004), in a research survey, indicate that managers in Kuwait are mainly motivated to pay dividends by two sets of value relevant motives. These are the “clientele-effect set” and the “signaling set”. They argue that dividend policies affect share value and are not determined residually, as suggested by Miller and Modigllani (1961). The findings of this study provide further empirical evidence on the value relevance of dividends and earnings for firms listed on the KSE. KSE was established in 1977. It was, however, reorganized in August 1983 as an independent financial institution managed by the Exchange Committee and the executive administration. KSE is one of the first and largest stock exchanges in the Middle East. Listed companies on the KSE are divided into seven sectors; banking, insurance, investment, real estate, industry, services and food. In September 2000, the Foreign Investment Law was issued by the Government to allow foreigners for the first time to invest in the KSE. The total market capitalization of the KSE increased consistently from US$ 59.5 billion in 2003 to US$ 122.3 billion in mid-2009, placing it as the second largest GCC stock market after Saudi Arabia. International Financial Reporting Standards (IFRS) are mandatory in Kuwait and the government controls the accounting and auditing professions. Hence, it can be argued that countries applying IFRS may allow varying degrees of deviation from clean surplus relationship than that observed by prior studies applying the US or other local Generally Accepted Accounting Principles (GAAPs). Therefore, it is possible that the information content of accounting information in Kuwait may vary. Moreover, equity ownership in Kuwait is often concentrated among small groups of major shareholders: the government and its agencies, dominant families, and institutional investors. These groups may influence

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the level and quality of disclosure, and may assert their power over the board to affect firm dividend policies, and hence the value relevance of accounting numbers. For example, Al-Kuwari (2009) provides evidence that government ownership has a significant effect in promoting dividend pay-outs for firms listed on the stock exchanges of GCC countries. Her results also reveal that these firms alter their dividend policy frequently and do not adopt a long-run target. Given these attributes, combined with an overall weak regulatory environment in Kuwait, it is possible that the information content of accounting variables and dividends in particular, may differ. The remainder of this paper is organized as follows. Section 2 reviews relevant prior research. Section 3, explains the research methodology employed in this study. Section 4 reviews descriptive statistics and empirical results. Section 5 provides additional analyses and Section 6 concludes.

2. Prior studies Ball and Brown (1968) are the first to examine the association between an accounting performance measure (e.g., earnings or cash flow from operations) and stock returns. They find evidence suggesting that earnings are associated with stock returns. They also find that the annual abnormal return adjustment is greater for earnings changes than for cash flow changes, suggesting that cash flows are less accurate in explaining the signs of abnormal security returns than accrual-based earnings. Ball and Brown argue that market participants have access to more timely sources of information about a firm's ability to generate future cash flows and hence, presume that accounting reports are not the only source of information available to market participants. Following Ball and Brown, a long stream of research examines the relative informativeness of earnings and cash flows. They broadly examine changes in security returns caused by accounting information (normally earnings announcements) and other value relevant economic events. Some of these studies repeat the work of Ball and Brown but in different settings (e.g., in different countries using interim earnings rather than annual earnings, or using shorter earnings announcement periods). Results of these studies report that the information content of published accounting numbers can be investigated empirically, by estimating unexpected accounting earnings and correlating them with unexpected changes in stock prices (e.g., Ali & Pope, 1995; Ball, 1972, 1978; Beaver, 1968; Beaver, Clarke, & Wright, 1979; Beaver & Dukes, 1972; Dechow, 1994; Grant, 1980; McLeay, Kassab, & Helan, 1997; Rayburn, 1986; Wilson, 1987). The other stream in MBAR attempts to explain values (valuation models) rather than value changes (return models). Lev and Ohlson (1982) argue that researchers have been almost exclusively concerned with the relationship between financial statements data and stock returns, while ignoring the essential role of accounting variables in asset valuation. They also argue (p.305) “… if the relevance of accounting information to investors is at issue, surely the extent to which this information accounts for (explains) the values of stock, rather than just triggers a change in these values, should be of major concern.” The conceptual advantages and disadvantages of return and valuation models have been considered by several studies (e.g., Beaver & Landsman, 1983; Gonedes & Dopuch, 1974; Kothari & Zimmerman, 1995; Lev, 1989; Lev & Ohlson, 1982). Beaver and Landsman (1983) support both return and valuation approaches rather than believing in the superiority of one over the other. They argue that a return approach and a cross-sectional valuation approach are not mutually exclusive, but represent two ways of extracting information from the data. They claim that each approach will provide information not provided by the other, and thus there is no reason to suspect dominance of one approach over the other. Kothari and Zimmerman (1995) provide empirical evidence on the superiority of valuation models over the return models in MBAR. They present an economically intuitive analysis which suggests that the estimated slope coefficient from the price model, but not from the return model, is unbiased. Furthermore, Lev (1989) concludes that the goodness of fit achieved by attempting to model the relationship between unexpected earnings and stock returns is very poor by the usual standards of econometrics. He argues that the likely reasons for this poor statistical performance are the poor specification of the estimated equation; the research design that does not consider the effect of firm-specific, industrial and macro-state factors; and the measurement errors in the earnings variable. Walker (1997) indicates that the poor design of the empirical model; earnings being anticipated by the market with access to superior information; unreliability of reported earnings as indicators of firm performance due to deviations and/or misapplication of Generally

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Accepted Accounting Principles (GAAPs); and the stock market being informationally inefficient, are possible reasons for the poor relationship between unexpected earnings and stock returns. Ohlson (1995) expresses firm market value as a linear function of book value and the present value of expected abnormal earnings, with abnormal earnings defined as current earnings minus a capital charge (equal to the risk free rate) times the opening book value. Ohlson (1995) also suggests additional assumptions of linear information dynamics where firm value can be re-expressed as a linear function of equity book value, clean surplus earnings, and dividends. Feltham and Ohlson (1995) extend Ohlson (1995) and develop a model of firm value and accounting data when the data disclose results from both operating and financial activities. Stark (1997) suggests that clean surplus earnings are value relevant only when its separate components have no additional predictive value over the total of the components. If the separate components of earnings have such an additional ability, then knowledge about clean surplus earnings components, rather than their sum, is important. The valuation approaches of Ohlson (1995), Feltham and Ohlson (1995), and Stark (1997) develop the theoretical structure for re-defining the relationship between accounting numbers and firm market value. Valuation models are increasingly being used to investigate various kinds of relationships involving a number of explanatory variables hypothesized to explain the variation in stock prices. Most of the empirical valuation research in recent years adopts Ohlson's valuation framework as a theoretical benchmark. Numerous studies in developed markets examine the value relevance of accounting information using the price model. These studies model market value as a function of book value and reported earnings (or their components). These studies primarily provide evidence on the value relevance of earnings and book value (e.g., Akbar & Stark, 2003b; Barth, Beaver, & Landsman, 1997; Bernard, 1995; Bettman, 2007; Bettman, Sault, & Welch, 2006; Brief & Zarowin, 1999; Collins, Maydew, & Weiss, 1997; Green, Stark, & Thomas, 1996; Hand & Landsman, 2005; Rees, 1997; Stark & Thomas, 1998). Some of these studies also use non-accounting control variables (e.g., growth, firm size, industry type, earnings sign, market share and risk) in their price models. For example, Green et al. (1996) estimate a valuation model that includes market share, industry concentration, firm gearing, industry gearing, and the squared difference between firm and industry gearing as control variables. They estimate the model with the control variables included, and for a reduced form after excluding the control variables. They find some of the control variables significant, although none are reliably so. The results also indicate that the control variables employed have only a marginal impact on the explanatory power of the model, and no impact on the significance of the remaining variables. Bernard (1995) is one of the first to estimate the value-relevance of dividends in developed markets using US data over the period 1978–1993. He compares the explanatory power of two price equations. First, he models market value on book value and the earnings forecasts for the subsequent four years. He then represents the value in terms of expected dividends rather than book value and abnormal earnings. Bernard concludes that the forecasted accounting variables (book value and abnormal earnings) explain about 68% of the cross-sectional variation in market value, while the explanatory value of dividends is only 29%. This suggests that the dividend model's ability to explain firm value over a limited time horizon is weak. The results indicate that the value relevance of accounting variables outperforms dividends, thus providing confirmatory evidence for the value relevance of accounting data. Brief and Zarowin (1999) indicate that Bernard's (1995) study provides a motivation for substituting dividends for earnings in valuation model relating price to book value and dividends. They argue that using dividends as a substitute for earnings in the valuation equation can be viewed as a test for the Modigliani and Miller (1959) early findings that dividends may have a greater correlation with a true measure of earnings potential – and thus stock price – than current earnings itself. Brief and Zarowin compare the value relevance of book value and dividends versus book value and earnings. Their results indicate that, overall, the variables, book value and dividends have almost the same explanatory power as book value and earnings. However, for firms with transitory earnings, dividends are found to have a greater explanatory power than earnings. Most studies that examine the value relevance of dividends in developed markets observe that dividends have a positive impact on firm value (e.g., Akbar & Stark, 2003b; Hand & Landsman, 2005; Rees, 1997). In the UK, Rees (1997) investigates the value relevance of dividends, capital structure and capital expenditure during 1987–1995. He finds that earnings distributed as dividends have a bigger impact on value than do earnings retained within the firm. He points out that the inclusion of dividends in the valuation equation improves the explanatory power of the model. Further dividends seem to be less influential in larger firms or in firms with a high return on equity. The results show a significant impact of

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capital expenditure on firm market value. However, there is no convincing evidence that equity value is affected by the capital structure. Akbar and Stark (2003b) investigate the relationship between net shareholder cash flows, dividends, capital contributions and firm market value during the years 1990–2001 using four different deflators (i.e., sales, number of shares outstanding, opening market value, and closing book value). They aim at investigating whether deflators play a part in establishing the estimated role of dividends in corporate valuation. The results reveal that the coefficients of net shareholder cash flows are negative and significant. The results also show a positive and significant relationship between dividends (the first component of net shareholder cash flows) and firm market value. The coefficients of capital contributions (the other component of net shareholder cash flows) are negative and significant in all estimated equations. Akbar and Stark (2003b) argue that dividends appear to capture some of the effects of book value and earnings on stock market price in the UK. They also indicate that deflators have no impact on the value-relevance of dividends in the UK. Hand and Landsman (2005) test the differing predictions that emerge in Ohlson's (1995) model by examining the information content of dividends. They find that dividends have information content in the US, and this information content is greatest when earnings are transitory. A recent stream of research examines the value relevance of accounting information in emerging markets. It is argued that due to market imperfections and the limited sources of reliable information in emerging markets compared to developed markets, stock price possibly fails to reveal completely all available company information, and hence, accounting numbers become more credible and powerful (i.e., relevant) for decision making than in developed markets (Lopes, 2002). Chen et al. (2001) empirically examine the value relevance of accounting information in the Chinese Stock Market from 1991 to 1998, and report that book value and earnings are value relevant in different stock market segments of China. Similar results are found by Ragab and Omran (2006), Hellstrom (2006), Bae and Jeong (2007), and Pourheydari et al. (2008) for firms listed in Egypt, Czech Republic, Korea, and Iran, respectively. Ragab and Omran (2006) investigate the value relevance of earning and book value in the Egyptian market from 1998 to 2002. They find that earnings and book value are all value-relevant. Their results also indicate that the value relevance of Egyptian financial accounting information is relatively greater than information in more mature financial markets. Hellstrom (2006) examines the value relevance of accounting information in the Czech Republic. She finds that the value relevance of earnings and book value in Czech companies is lower than that in Sweden as an example of a well-developed market. Her results, however, indicate an improvement in the quality of the Czech financial accounting information during the research period 1994–2001. Bae and Jeong (2007) investigate the value-relevance of earnings and book value of industrial firms listed on the Korean Stock Exchange and affiliated with Korean business groups, known as chaebols, from 1987 to 1998. A unique feature of a chaebol is that controlling power is heavily concentrated in an individual or a single family. Bae and Jeong's study shows that there is a substantial difference in the degree of value relevance among firms within the country; the value relevance of earnings and book value is significantly smaller for firms affiliated with business groups, and that the governance structure is a main determinant of value relevance. Pourheydari et al. (2008) provide evidence that dividends, earnings and book value are all value relevant for firms listed on the Tehran Stock Exchange (TSE) from 1996 to 2004. They report that the value relevance of the combination of book value and earnings, and the combination of book value and dividends are approximately equal. They also find that the value relevance of all variables is decreasing during the study period. In the Kuwaiti context, few studies provide evidence that earnings and book value are value relevant for firms listed on the KSE (e.g., Alfaraih & Alanezi, 2011; ElShamy & Al-Qenae, 2005). ElShamy and Al-Qenae (2005) investigate the change in the value relevance of earnings and book value over the period 1980 to 2001. They find that earnings and book value are jointly and individually value relevant. Their results also show that the combined value relevance of earnings and book value has increased over time. Further, the incremental value relevance of earnings has increased over time, while that of book value has declined. Alfaraih and Alanezi (2011) examine the value relevance of earnings and book value for firms listed on the KSE during the period 1995–2006. They find that earnings and book value are, jointly and individually, positively and significantly related to stock prices, while the value relevance of both variables is found to be higher than findings observed in some developed and emerging countries. Al-Deehani and Al-Loughani (2004), in a research survey, indicate that managers in Kuwait are mainly motivated to pay dividends by two sets of value relevant motives. These are the “clientele-effect set” (e.g., meeting shareholders' requirements for income, maintaining their loyalty, and supporting share price to maximize

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their wealth); and the “signaling set” (e.g., actions to indicate future profits, actions to get external finance, and actions to help prevent a takeover). They argue that dividend policies do in fact affect share value and are not determined residually, as suggested by Miller and Modigllani (1961). Miller and Modigliani believe that firm value is determined only by the investment and operating decisions that generate cash flows. Dividend policy is just a ‘financial’ decision, or a way of dividing up operating cash flows among investors. Given the above, the role of dividends in determining stock price for firms listed on the KSE remains a contentious and empirical issue in the literature. In addition to examining the value relevance of earnings and book values, this study is the first to examine the value relevance of dividends utilizing Kuwaiti data. Given that International Financial Reporting Standards (IFRSs) are mandatory in Kuwait and that the government controls the accounting and auditing professions, it can be argued that applying IFRS may allow varying degrees of deviation from clean surplus relationship than that observed by prior studies applying the US or other local GAAPs. Hence, it is possible that the information content of accounting information in Kuwait may vary. Further, companies in Kuwait are characterized by large block and pyramid shareholdings; unusually complex corporate structures; poor disclosure and transparency practices; concentration of power in the hands of key directors; and interlocking directorships. 3. Research methodology This study employs the price valuation model suggested by Ohlson (1995), where firm value is expressed as a linear function of equity book value, earnings, and net shareholder cash flows or (net dividends). A two-factor model that relates firm market value to book value and contemporaneous earnings is initially estimated (e.g., Bettman, 2007; Bettman et al., 2006; Collins et al., 1997; Stark & Thomas, 1998). The dividend term is omitted (or assumed to be subsumed in the earnings term) because of its likely multicollinearity with earnings (e.g., Stark & Thomas, 1998). The model estimated in this study, referred to as Model (I), is: MV it ¼ α 0 þ α 1 BV it þ α 2 Eit þ εit

ðIÞ

where MVit = market value of common stock; BVit = book value of common stock; Eit = earnings before extraordinary and exceptional items of firm i in year t; and εit = the error term. Numerous empirical studies provide evidence on the significance of current earnings and book value at time t in explaining firm value (e.g., Alfaraih & Alanezi, 2011; Bettman, 2007; Bettman et al., 2006; Collins et al., 1997; ElShamy & Al-Qenae, 2005; Green et al., 1996; Rees, 1997; Stark & Thomas, 1998). For instance, Barth et al. (1997) argue that the main reason for the value relevance of current earnings and book value is that earnings proxy for the current value of the firm, whereas book value represents its liquidation value. Berger, Ofek, and Swary (1996) argue that book value represents the resources a firm can allocate to generating future earnings. Ohlson (1995) suggests that dividends may be relevant in determining stock prices. Most empirical studies that examine the value relevance of dividends observe that dividends have a positive impact on corporate valuation using number of shares as a deflator (e.g., Akbar & Stark, 2003b; Hand & Landsman, 2005; Rees, 1997). Akbar and Stark (2003b) argue that dividends act as a signal for private information held by managers about firm market value. Another interpretation is presented by Aleksanyan et al. (2009) who suggest that dividends may be viewed as a proxy for the firm's permanent component of earnings and thus as having ‘information content’. The second model investigated in this study, referred to as Model (II), is: MV t ¼ α 0 þ α 1 BV it þ α 2 Eit þ α 3 Dit þ εit

ðIIÞ

where Dit = dividends of firm i in year t. Model (II) is estimated with a restriction implying that net capital or ‘capital contributions’ are not value relevant, and are thus omitted from the estimated equation (e.g., Rees, 1997). Prior studies speculate that it may not be possible to rely on the results of Model (II) or to place complete weight on estimated coefficients of dividends, because dividends capture some of the effects of earnings and book value on market value. Thus the inclusion of dividends may incorporate an effective

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indicator of the permanent component of earnings, thereby reducing the value relevance of earnings and/ or book value (e.g., Brief & Zarowin, 1999; Rees, 1997). Akbar and Stark (2003b) find that the coefficients of earnings and book value are almost always lower when dividends are included in the valuation equation. Hand and Landsman (2005) argue that dividends have information content, and that this information content is greatest when earnings are transitory. This is consistent with the Modigliani and Miller (1959) early findings that dividends may have a greater correlation with a true measure of earnings potential – and thus stock price – than current earnings itself. It can be argued that rational investors usually ignore the transitory component of corporate earnings in determining market values and instead concentrate on the estimated permanent component. Furthermore, given the algebraic properties of an accounting system based on clean surplus relation, a valuation model may be derived in terms of book value and dividends. Motivated by Bernard (1995) and Brief and Zarowin (1999), earnings are replaced with dividends in Model (I). Thus, the third model investigated in this study, referred to as Model (III), is: MV it ¼ α 0 þ α 1 BV it þ α 2 Dit þ εit :

ðIIIÞ

Brief and Zarowin (1999) argue that using dividends as a substitute for earnings in the valuation equation can be viewed as a test for the Modigliani and Miller (1959) proposition in which dividends may have as much or more correlation with share price as current earnings. Brief and Zarowin find the explanatory power of book value and earnings almost indistinguishable from book value and dividends. They further argue that dividends are strongly positive in models of value, and that the influence of dividends is, partially, dependent on the permanence of the reported earnings. Thus, in firms with transitory earnings, dividends have greater explanatory power than earnings. A similar result is also found in Hand and Landsman (2005). Furthermore, Skinner and Soltes (2008) present evidence that dividends are informative about earnings quality, where high quality earnings are those more likely to be sustainable in the future (e.g., Penman, 2001). They suggest that dividend policies are based on managers' assessment of firms' long-run sustainable earnings. Skinner and Soltes view distributed earnings as being relatively permanent and undistributed earnings as relatively transitory. They argue that the increase in earnings that managers consider permanent will be complemented by increases in dividends (i.e., pay-out ratios), while increases in earnings that are largely transitory will not. To further examine the value relevance of dividends, earnings in Model (I) are split into dividends declared (or paid) and earnings retained. This allows the model to differentiate between the weight of permanent and transitory earnings. Thus, the fourth model investigated in this study, referred to as Model (IV), is: MV it ¼ α 0 þ α 1 BV it þ α 2 Dit þ α 3 ðEit −Dit Þ þ εit

ðIVÞ

where Dit = dividends declared (or paid); and (Eit − Dit) = earnings retained of firm i in year t. Constant terms and stochastic error terms are added into the models to capture the effect of potential unexplained ‘other’ value relevant information omitted from the models. An underlying assumption of the analysis is that those omitted variables are not correlated with the variables of interest in the study enough to affect the inferences drawn. Models (I) to (IV), without proper control for cross-sectional scale differences, are likely to bias both the estimated coefficients and the regression's explanatory power. A possible consequence of the presence of cross-sectional scale differences and heteroscedasticity is that one cannot determine with confidence whether the standard error of estimated coefficients is positively or negatively biased. To mitigate the econometric effects of scale, models are deflated using number of shares (e.g., Bettman, 2007; Hand & Landsman, 2005; Kothari & Zimmerman, 1995; Rees, 1997). To control for the impact of the global financial crisis (GFC), FCD — a dummy ‘control’ variable is included in the valuation equations. FCD is given the value 0 for each observation before 2008 (pre-GFC) and the value 1 for observations during the financial crisis (2008 and 2009). Thus, Models (I) to (IV) are restated, respectively, as MV it ¼ α 0 þ α 1 BV it þ α 2 Eit þ α 3 FC D½0;1

ðIÞ

MV t ¼ α 0 þ α 1 BV it þ α 2 Eit þ α 3 Dit þ α 4 FC D½0;1

ðIIÞ

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MV it ¼ α 0 þ α 1 BV it þ α 2 Dit þ α 3 FC D½0;1

ðIIIÞ

MV it ¼ α 0 þ α 1 BV it þ α 2 Dit þ α 3 ðEit −Dit Þ þ α 4 FC D½0;1 þ εit :

ðIVÞ

The variables used in this study are defined as follows: 1. MV, the market value of equity, is measured as the share price on a specific date multiplied by the number of ordinary shares outstanding. To ensure that the information in the financial statements for a given financial year is reflected in the market price, this study uses the firm market value three months after the balance sheet date, bearing in mind that firms listed on the KSE usually release their annual accounts two to three months after the year-end; 2. BV, book value, is measured as the sum of shareholders equity capital and reserves; 3. E, earnings, are measured as net income after tax; 4. D, dividends, are measured as dividends declared (or paid) during the financial year; 5. (E − D), earnings retained, are measured as earnings minus dividends declared (or paid); and 6. FCD, a dummy ‘control’ variable for the impact of the global financial crisis (GFC). All models are estimated using ordinary least squares (OLS) techniques to estimate the coefficients. White's (1980) heteroscedasticity-corrected variances and standard errors are used to diminish the effects of any remaining heteroscedasticity. The data for this study were extracted from the KSE Shareholders Annual Guides and Corporate Fact Sheets, and the annual financial reports for Kuwaiti firms for the period 2003 to 2009. The total number of companies listed on the KSE at the time of data collection was 195 firms, of which 121 firms are non-financial. All non-financial firms that have complete data for any given year were extracted and included in the annual cross-section for the appropriate calendar year. There are 56 firms in the 2003 sub-sample; 67 firms in 2004; 93 firms in 2005; 104 firms in 2006; 109 firms in 2007; 117 firms in 2008; and 121 firms in 2009. The final pooled cross sectional sample includes 667 firm-year observations. The study is restricted to all non-financial firms, because reporting systems for financial intuitions (Banking, Insurance, and Investment) are different from standard accounting systems (e.g., Green et al., 1996; Rees, 1997; Stark & Thomas, 1998; Hand and Landsman, 2005, Lo & Lys, 2000; Akbar & Stark, 2003b). Tables 1 and 2 present the sample descriptive statistics and the pair-wise correlations between the deflated variables used in the regression Models (I) to (IV) for the pooled sample. Table 1 shows a significant variation in market values per share with an average (median) of US$ 0.76 (0.33). Sample firms have average (median) earnings per share of US$ 0.09 (0.04) with a minimum of US$ −0.77 and a maximum of US$ 1.06. Finally, the average (median) dividend per share is US$ 0.06 (0.03). Table 2 reveals that the highest correlation coefficient among independent variables is 0.71, suggesting that multicollinearity does not appear to be a problem in this study. Table 3 presents statistics of dividends in the KSE during the study period (2003–2009). It shows that the mean dividend pay-out ratio tends to increase over time. It ranges from 14.49% in 2003 to 28.19% in 2009. Consistent with Al-Deehani and Al-Loughani (2004), this suggests that dividends are used by Table 1 Sample descriptive statistics for all variables for the pooled sample (2003 to 2009) — using number of shares as the deflator.

Maximum Minimum Mean Median Standard deviation

MVt

Et

BVt

Dt

(E − D)t

$7.20 0.04 0.76 0.33 0.51

$1.06 −0.77 0.09 0.04 0.07

$3.06 0.04 0.35 0.17 0.13

$0.19 0.00 0.06 0.03 0.06

$0.27 0.00 0.02 0.01 0.15

Where MVt, is the market value in year t measured three months after the balance sheet date; BVt, is book value in year t measured as the sum of equity capital and reserves; Et, is earnings in year t measured as net income after tax; Dt, is dividends in year t measured as dividends declared (or paid); and (E − D)t, is earnings retained in year t. (Figures in millions of USD: the average exchange rate with the Kuwaiti Dinar (KD) is approximately 1KD: US$ 3.60).

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Table 2 Pearson correlations between all variables for the pooled sample (2003 to 2009) — using number of shares as the deflator.

MVt Et BVt Dt (E − D)t

MVt

Et

BVt

Dt

(E − D)t

1.00 0.61 0.67 0.58 0.43

1.00 0.64 0.71 0.52

1.00 0.47 0.46

1.00 0.04

1.00

Where MVt, is the market value of equity in year t measured three months after the balance sheet date; BVt, is book value in year t measured as the sum of shareholder equity capital and reserves; Et, is earnings in year t measured as net income after tax; Dt, is dividends in year t measured as dividends declared (or paid); and (E − D)t, is earnings retained in year t.

managers in Kuwait to boost investors' confidence and support share price, noticeably during the financial crisis period. 4. Empirical results The discussion of the results is based on estimating Models (I) to (IV) for the pooled sample using number of shares as the deflator. Models (I) to (IV) are also estimated on all annual cross-sections (2003–2009) (untabulated) with inferences that do not differ in a qualitative sense from those drawn from the pooled sample. The results are presented in Table 4. The adjusted R 2s vary from 57.1% to 61.3%. The results indicate that share price is positively dependent on book value and earnings. The coefficients on book value are consistently positive and significant (at least at the 1% level) in all estimated regressions in which this variable features. This suggests that book value is value-relevant. The estimated coefficients on earnings are positive and significant (at least at the 5% level), suggesting that earnings are also value relevant. These results reinforce previous research findings reported in developed and emerging markets (e.g., Green et al., 1996; Rees, 1997; Collins et al., 1997: Stark & Thomas, 1998; Chen, Chen, & Su, 2001; ElShamy & Al-Qenae, 2005; Bettman et al., 2006; Bettman, 2007; Alfaraih & Alanezi, 2011). However, results pertaining to Model (II) show that the estimated coefficient on dividends is insignificant. One interpretation of this result is that dividends may be subsumed in the earnings term because of the high correlation between the two variables (e.g., Stark & Thomas, 1998). Results reported from estimating Model (III) provide evidence that dividends are significantly related to share price when substituted for earnings in the valuation equation. Furthermore, the explanatory power of the model including book value and earnings is almost indistinguishable from that including book value and dividends (Pourheydari, Aflatooni, & Nikbakhat, 2008). The positive and significant influence of dividends on market share price can be interpreted as reinforcing the importance of dividends as a proxy for the firm's permanent component of earnings (e.g., Brief and Zarowin, 1999; Hand & Landsman, 2005). This suggests that dividends may be capturing some of the effects of earnings and book value on market share price and thus that the inclusion of dividends in the valuation equation may incorporate an effective indicator of the permanent component of earnings, thereby reducing value relevance of earnings and/or book value (e.g., Brief & Zarowin, 1999; Rees, 1997).

Table 3 Statistics of dividends policy in the KSE during the study period (2003–2009). Year

No. of non-financial firms listed at KSE

No. of non-financial firms paid dividend

Pay-out ratio Mean

Median

2003 2004 2005 2006 2007 2008 2009

56 67 93 104 109 117 121

51 58 89 88 97 54 53

14.49% 18.26% 21.29% 23.07% 25.10% 26.02% 28.19%

8.18% 13.11% 14.51% 19.35% 20.01% 21.27% 25.91%

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Table 4 Estimating models of corporate valuation on pooled data (2003–2009) (OLS estimation based on adjusted White's Heteroscedasticity-Consistent S.E.'S) — number of shares as the deflator. Model (I): MVit = α0 + α1BVit + α2Eit + α3FCD[0,1] + εit Coefficients Intercept

BVit

Eit

FCD[0,1]

No. of observations

Adjusted R2

Durbin–Watson

198.28 (0.000)

16.86 (0.000)

2.741 (0.006)

−4.035 (0.000)

667

59.4%

1.891

Model (II): MVt = α0 + α1BVit + α2Eit + α3Dit + α4FCD[0,1] + εit Coefficients Intercept

BVit

Eit

Dit

FCD[0,1]

No. of observations

Adjusted R2

Durbin–Watson

211.30 (0.000)

9.781 (0.000)

1.263 (0.040)

0.532 (0.595)

−4.059 (0.000)

667

57.1%

1.931

Model (III): MVt = α0 + α1BVit + α2Dit + α3FCD[0,1] + εit Coefficients Intercept

BVit

Dit

FCD[0,1]

No. of observations

Adjusted R2

Durbin–Watson

236.22 (0.000)

18.251 (0.000)

1.972 (0.026)

−4.674 (0.000)

667

59.7%

1. 771

Model (IV): MVt = α0 + α1BVit + α2Dit + α3(Eit − Dit) + α4FCD[0,1] + εit Coefficients Intercept

BVit

Dit

(Eit − Dit)

FCD[0,1]

No. of observations

Adjusted R2

Durbin–Watson

171.87 (0.000)

16.824 (0.000)

2.388 (0.018)

1.926 (0.023)

−4.062 (0.000)

667

61.3%

2.006

Where MVt, is the market value of equity in year t measured three months after the balance sheet date; BVt, is book value in year t measured as the sum of shareholder equity capital and reserves; Et, is earnings in year t measured as net income after tax; Dt, is dividends in year t measured as dividends declared (or paid); and (E − D)t, is earnings retained in year t.

Model (IV) splits up earnings (Et) into dividends declared/or paid (Dt), and earnings retained (Et − Dt). Results from estimating this model reveal that the estimated coefficients on dividends and earnings retained are positive and significant (at least at the 5% level). This result reemphasizes Skinner and Soltes' (2008) view of earnings distributed as being relatively permanent and of undistributed earnings as transitory. This suggests that the increase in earnings which managers consider permanent will be complemented by increases in dividends (defined using pay-out ratios), while increases in earnings that are largely transitory will not. The coefficient on the financial crisis dummy variable (FCD) is negative and significant in all estimated equations which – not surprisingly – indicates that stock prices in the Kuwaiti market are negatively affected by the financial crisis. Table 4 also reveals that autocorrelation is not a serious problem. The Durbin–Watson d statistics are very close to 2 in all models, providing no evidence of first-order autocorrelation. Given that there is no clear cut optimal deflator, in terms of removing the effects of scale or heteroscedasticity (e.g., Akbar & Stark, 2003a; Barth & Clinch, 2009; Easton & Sommers, 2003); and that using number of shares as a single-variable deflator may include bias, and thus may generate an asymmetric and skewed distribution to both deflated regression variables and the error term, Models (I) to (IV) are repeated using “total assets plus sales” as a composite-scale proxy to diversify any scaling deficiencies inherent in a single variable scale (results untabulated). The results of estimating Models (I) to (IV) using number of shares as a deflator are further verified when using “total assets plus sales” as a deflator, indicating that deflators have no impact on the results in this study. Table 5 reports the adjusted R 2 statistics of estimating Models (I) to (IV) for the annual cross-sections (2003–2009) of firms included in the study. The Table reveals a declining trend in the explanatory power of estimated price models – measured by adjusted R 2 – in the KSE during the pre-GFC period, followed by

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Table 5 Adjusted R2 statistics of estimating Models (I) to (IV) for annual cross-sections (2003–2009) — using number of shares as the deflator.

2003 2004 2005 2006 2007 2008 2009

Model (I)

Model (II)

Model (III)

Model (IV)

64.2% 60.1% 56.2% 55.8% 54.1% 43.8% 48.8%

71.9% 68.4% 60.2% 58.8% 54.0% 43.7% 45.2%

63.8% 62.7% 58.3% 55.1% 52.7% 46.9% 47.1%

66.7% 64.3% 58.0% 56.4% 55.6% 45.2% 46.9%

Where: Model (I): MVit = α0 + α1BVit + α2Eit + α3FCD[0,1]. Model (II): MVt = α0 + α1BVit + α2Eit + α3Dit + α4FCD[0,1]. Model (III): MVit = α0 + α1BVit + α2Dit + α3FCD[0,1]. Model (IV): MVit = α0 + α1BVit + α2Dit + α3(Eit − Dit) + α4FCD[0,1] + εit.

sharp decreases during the crisis (2008–2009). This result is consistent with the assertion in the literature that financial statements have lost their value relevance over time. Recently, contradicting inferences on the direction of the change in the association between accounting numbers and the market value of common equity have appeared among market-based accounting studies. Some researchers report a decline in the value relevance of accounting information over time, consistent with the assertion that traditional financial statements have lost their value relevance (e.g., Balachandran & Mohanram, 2011; Core et al., 2003; Dontoh et al., 2004; Elliott & Jacobsen, 1991; Entwistle & Phillips, 2003; Francis & Schipper, 1999; Lev & Zarowin, 1999; Ramesh & Thiagarajan, 1995). In contrast, other studies find an increasing trend in the value relevance of accounting information (e.g., Collins et al., 1997; Cortijo, Palmon, & Yezegel, 2009). Pourheydari et al. (2008) argue that some possible reasons for the declining trend in the information content of accounting information in price valuation models are: concentrating on future growth opportunities; focusing on capital gain compared with earnings and dividend per share; the gap between book value and market values of assets (inflation effect); and the intensive fluctuations in capital markets. 5. Additional analyses The value relevance literature identifies several factors that influence the information content of accounting data such as industry type; firm size; positive versus negative earnings; firm age; and earnings persistence (e.g., Barth et al., 1997; Chen et al., 2001; Hellstrom, 2006). First, Model (IV) is repeated incorporating industry type to control for potential industry effect. Three industry dummy variables representing industrial, service, and food industries are added to the model. The Real Estate industry has not been assigned a dummy variable (the benchmark variable) to avoid perfect collinearity (the dummy variable trap). The industry of the firm is expected to provide some common effect with respect to the value relevance of accounting information. Thus, the fifth model examined in this study, referred to as Model (V), is: MV it ¼ α 0 þ α 1 BV it þ α 2 Dit þ α 3 ðEit −Dit Þ þ α 4 FCD½0;1 þ α 5 DInd‐INDit þ α 6 DInd‐SERV þ α 7 DInd‐FOODit þ εit

ðVÞ

where DInd-INDit is a dummy variable with value 1 for companies in the industrial sector, 0 otherwise; DInd-SERVit is a dummy variable with value 1 for companies in the service sector, 0 otherwise; and DInd-FOODit is a dummy variable with value 1 for companies in the food sector, 0 otherwise. The results of this analysis are reported in Table 6. Table 6 shows that none of the industry dummy variables is significant. The inferences on all other variables remain unaffected, suggesting that the results reported in Table 4 are not driven by industry effects. Second, our sample firms are separated into small and large firms by the median values of market capitalization for each year. Then, within each size group, Model (IV) is repeated to estimate the value

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Table 6 Estimating the industry effect on corporate valuation/pooled data (2003–2009) (OLS estimation based on adjusted White's Heteroscedasticity-Consistent S.E.'S) — number of shares as the deflator. Model (V): MVit = α0 + α1BVit + α2Dit + α3(Eit − Dit) + α4FCD[0,1] + α5DInd-INDit + α6DInd-SERVit + α7DInd-FOODit + εit Coefficients Intercept

BVit

171.87 14.215 (0.000) (0.000) No. of observations: 2 Adjusted R Durbin–Watson

Dit

(Eit − Dit)

FCD[0,1]

α5DInd-INDit

α6DInd-SERVit

α7DInd-FOODit

2.503 (0.009) 667 63.4% 1.86

1.766 (0.035)

−3.459 (0.000)

0.824 (0.356)

0.388 (0.643)

0.291 (0.769)

Where MVt, is the market value of equity in year t measured three months after the balance sheet date; BVt, is book value in year t measured as the sum of shareholder equity capital and reserves; Et, is earnings in year t measured as net income after tax; Dt, is dividends in year t measured as dividends declared (or paid); (E − D)t, is earnings retained in year t; DInd-INDit is a dummy variable with value 1 for companies in the industrial sector, 0 otherwise; DInd-SERVit is a dummy variable with value 1 for companies in the services sector, 0 otherwise; and DInd-FOODit is a dummy variable with value 1 for companies in the food sector, 0 otherwise.

relevance of book value and earnings (expressed in Model (IV) as dividends declared (or paid) and retained earnings) for small versus large firms. Out of 667 observations, 281 observations are classified as large (42.13%). The results indicate that the explanatory power of accounting information is higher for large firms. Large firms have an adjusted R 2 of 55.2%, while small firms show an adjusted R 2 of 46.6%. To evaluate whether the difference in the adjusted R 2s is statistically significant, we follow Cramer's (1987) statistical approach which provides a way to examine the degree of difference in the adjusted R 2s, assuming independence between the two groups, although not in a rigorous way. The difference in R 2 of 8.6% is statistically significant. The information content of large firms' accounting data is expected to be higher than for small firms (e.g., Collins et al., 1997). Small firms are more likely to report losses, suggesting less value-relevance. Further, large firms have more analysts following them than small firms; so accounting information is more easily incorporated into stock market value. The inferences on book value and earnings (expressed as dividends declared (or paid) and retained earnings) remain unaffected. 6. Conclusions The main objective of this study is to investigate the value relevance of earnings, book value and dividends utilizing Kuwaiti data as an example of an emerging GCC market. The study uses a sample of 667 non-financial firm-year observations listed on the KSE over the period 2003 to 2009. Kuwait is the third largest GCC capital market in which International Financial Reporting Standards (IFRSs) are mandatory and the government controls the accounting and auditing professions. Prior studies have primarily examined the value relevance of earnings and book value for the KSE-listed firms, whereas the role of dividends in determining stock price remains a contentious and empirical issue in the literature. Kuwait has a unique institutional setting in which firm ownership is concentrated among small groups of major shareholders who may directly or indirectly influence the level and quality of disclosure and may assert their power over the board to affect firm dividend policies. Given these poor disclosure and transparency practices, combined with an overall weak regulatory environment in Kuwait, it is possible that the information content of accounting variables, and particularly dividends, may differ. After controlling for the effect of the global financial crisis, empirical results provide evidence on the value relevance of book value and earnings in valuation models in the KSE. The estimated coefficients on book value and earnings are all consistently positive and significant. Dividends are not value relevant in the presence of earnings in the valuation model. However, when dividends are substituted for earnings in the regression equation, they become value relevant. The results also indicate that the explanatory power of the model including both book value and earnings is almost indistinguishable from that of book value and dividends. It is argued that dividends seem to be capturing some of the effects of earnings and book value on market share price, or to be acting as a proxy for the permanent component of earnings, thereby reducing the value relevance of earnings and/or book value. The study reemphasizes the view of Skinner and Soltes (2008) of distributed earnings as being relatively permanent and undistributed earnings as

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being relatively transitory. Thus splitting earnings into dividends declared (or paid) and earnings retained results in each of the two variables becoming value relevant. Results from estimating the annual cross-sections from 2003 to 2009, provide evidence that the value relevance of accounting information (measured by R 2values) in Kuwait has declined over time. This result is consistent with the assertion in the literature that financial statements have lost their value relevance. Furthermore, the average dividend pay-out ratio tends to increase over time, indicating that dividend policies do matter in the KSE and that dividends in Kuwait are used to boost investors' confidence and support share price, noticeably during the global financial crisis period. 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