The Adjustment of Stock Prices to New Information

Eugene F. Fama; Lawrence Fisher; Michael C. Jensen; Richard Roll

International Economic Review, Vol. 10, No. 1. (Feb., 1969), pp. 1-21.
Outline
• Introduction
• Hypothesis Development
• Sample and methodology
• Results
• Conclusion
Introduction
• Seminal article in event study methodology to examine
behaviour of prices around financial disclosures (earnings
announcement, dividend announcement, mergers and
acquisitions etc.).
• Previous studies give evidence of an efficient market.
• No study on the speed of adjustment of security prices to
specific type of new information.
• Objective of the paper : examine the process by which common
stock prices adjust to the information contained in a stock split.
• Goes beyond the normative theories of what should investment
and financing of a company’s policy be to positive theories of
what might be the effect of such policy to a company’s stock
price.
Hypothesis Development
• Research Question

• Is there normally some "unusual" behavior” in the rates of return on a split

security in the months surrounding the split?

• If splits are associated with "unusual" behavior of security returns, to what

extent can this be accounted for by relationships between splits and changes
in other more fundamental variables?
Hypothesis Development
• Larger fraction of stock splits are closely followed by increase in
dividend.
• When dividends are increased, there is a reluctance to reduce them
in the future (Lintner, 1956).
• Because of this, dividends are only increased when the firm is certain
it can continue with the payment in the future.
• Implies that dividend payment contains information about a firm’s
future earning and payment potential.
Hypothesis Development

Price effect
High returns in vanishes when
period before information about
the split dividend is taken
into account
Sample and methodology
• The data
• Stock Split: “an exchange of shares in which at least 5 shares are distributed
for every 4 formerly outstanding”. (the event)
• At least 24 months of price dividend data around the split data.
• Period covered: January 1927 – December 1959
• 940 splits on the New York Stock Exchange
• 622 securities
• 60% of the splits have more than 300 months data available
• Split security must be listed on the NYSE for at least 12 months before and 12
months after the split.
Sample and methodology
Sample and methodology
• Tests of model specification
• Least squares to estimate βj 𝑎𝑛𝑑 αj
• residuals in eq (1) are non-zero in months close to the split ∴
assumptions about the error term are not valid.
• If those months were included in the sample period, it will lead to
specification error for the estimates of β 𝑎𝑛𝑑 α ∴ they were excluded.
• Exclusion process:
•Obtained estimates of βj 𝑎𝑛𝑑 αj for each security j
• Compute residuals for a number of months before and after the split.
•Exclude months where positive residuals are different from negative
residuals.
•Exclusion of 15 months before split for all securities and 15 months after
the split for splits followed by dividend decrease.
Sample and methodology
Sample and methodology
• Linearity  ✔
• Homoscedasticity  ✔
• Serial Independence  ✔
• Normality X
• However given the large sample size,
least square method give estimates
that are not biased and are consistent
(Wise, 1963).
• Mean absolute deviation is used to
measure variability because it is more
stable when compared to variance or
standard deviation (Fama, 1965).
Sample and methodology
• Regressions of security returns on market returns over time are a
satisfactory method for abstracting from the effects of general market
conditions on the monthly rates of return on individual securities.

• Oversimplified model of price formation because general market

conditions alone do not determine the returns on an individual security.
• Omitted variables are impounded in the error term, µ
• Stock split associated with abnormal behavior in returns during months
surrounding the split date should be reflected in the estimated
regression residuals of the security for these months.
Empirical Results: Effects of spilt on
Returns
• Is the stock market "efficient" in the sense that stock prices adjust very rapidly to new
information?
• Association of splitting with specific types of return behavior. (Do stock prices adjust rapidly to
the split information or information implicit in a split?) An important question???
• 1. Cross-sectional averages of estimated regression residuals in the months surrounding split
dates month 0 as the month in which the effective date of a split occurs. Month 1 as the month
immediately following the split month while month -1 is the month preceding.
• 2. “Increased” or “Decreased” dividend is measured relative to average dividends paid by all
securities on the New York Stock Exchange during the relevant time periods.
• 3. The dividend change ratio as total dividends paid in the twelve months after the split, divided
by total dividends paid during the twelve months before the split.
• 4. Dividend "increases" are then defined as where the dividend change ratio of the split stock is
greater than the ratio for the Exchange as a whole, while dividend "decreases” include cases of
relative dividend decline.
Average residuals of month
is the sample regression residual for security j in the
month m and N is the number of splits for which data are
available in month m.
Interval of

as cumulative average residuals from the month

-29 to month m.
Continued……
• as the average and cumulative average residuals
for splits followed by "increased" (+) and "decreased" (-) dividends.

• “Increased" and “Decreased" dividends provide a simple and

convenient way of abstracting from general market dividend changes
in classifying year-to-year dividend changes for individual securities.

• Further discussion in table 2, 3, and figure 2, 3.

 Positive
residuals
before split
Negative
residuals
after split
date
Findings from table
• The average residuals (u) in the twenty-nine months prior to the split are uniformly positive for all
splits and for both classes of dividend behavior.
• However, the author states this can hardly be attributed entirely to the splitting process due to
higher median time between the announcement date and effective date.
• In a random sample of fifty-two splits from data the median time between the announcement date
and the effective date of the split was 44.5 days.
• Jaffe (1957) found that the median time between announcement date and effective date was sixty-
nine days in 100 random split sample between 1/1/1946 and 1/1/1957.
• For both samples in only about 10 per cent of the cases is the time between announcement date
and effective date greater than four months.
• Thus it seems safe to say that the split cannot account for the behavior of the regression residuals as
far as two and one-half years in advance of the split date.
• Rather authors suggest the obvious sharp improvement occur, relative to the market, due to the
earnings prospects of the company sometime during the years immediately preceding a split.
• Thus it is concluded that companies tend to split their shares during "abnormally“ good times-that is
during periods of time when the prices of their shares have increased much more than would be
implied by the normal relationships between their share prices and general market price behavior.
 No split when
market index is
lowest

higher split when

market index is
highest
Findings from table 3
• From Table 3, it is clear that for the exchange as a whole the number
of splits increases dramatically following a general rise in stock prices.
• Thus it is concluded that splits tend to occur during general "boom"
periods, and the particular stocks that are split will tend to be those
that performed "unusually" well during the period of general price
increase.
• It is important to note that when all splits are examined together, the
largest positive average residuals occur in the three or four months
immediately preceding the split, but that after the split the average
residuals are randomly distributed about 0.
General Findings
• Figure 2b the cumulative average residuals rise dramatically up to the split
month, but there is almost no further systematic movement thereafter.
• The total change in the cumulative average residual during the two and one-half
years following the split is less than one percentage point, in spite of the fact
that 71.5 per cent (672 out of 940) of all splits experienced greater percentage
dividend increases in the year after the split than the average for all securities on
the N.Y.S.E.
• When a split is announced or anticipated, the market interprets this as greatly
improving the probability that dividends will soon be substantially increased.
• It is possible that the large price increases in the months immediately preceding
a split are due to altering expectations concerning the future earning potential of
the firm rather than to any intrinsic effects of the split itself.
Findings regarding “Increased
dividend”
• It is not surprising that the average residuals (Figure 3a) for stocks in
the dividend "increased" class are in general slightly positive, in the
year after the split, so that the cumulative average residuals (Figure
3c) drift upward.
• Only slight additional adjustment is necessary when the dividend
increase actually takes place. By one year after the split the returns
on stocks which have experienced dividend "increases“ mostly
resumed their normal relationships to market returns since from this
point onward the average residuals are small and randomly scattered
about zero.
Findings regarding “Decreased
dividend”
• However, the behavior of the residuals for stock splits associated with "decreased "dividends
provides the strongest evidence in favor of split hypothesis.

• For stocks in the dividend "decreased" class the average and cumulative average residuals
(Figures 3b and 3d) rise in the few months before the split but then plummet in the few months
following the split, when the anticipated dividend increase is not forthcoming.
• The hypothesis is further reinforced by the observation that when a year has passed after the
split, the cumulative average residual has fallen to about where it was five months prior to the
split. It is probably about the earliest time reliable information concerning a possible split is likely
to reach the market.

• Thus by the time it has become clear that the anticipated dividend increase is not forthcoming,
the apparent effects of the split seem to have been completely wiped away, and the stock's
returns have reverted to their normal relationship with market returns.
Overall Findings
• In sum, data suggest that once the information effects of associated dividend
changes are properly considered, a split has no net effect on common stock
returns.
• The data present important evidence on the speed of adjustment of market
prices to new information.
• In spite of the fact that a substantial majority of split securities do experience
dividend "increases," when all splits are examined together (Figure 2), the
average residuals are randomly distributed about 0 during the year after the
split. Thus there is no net movement either up or down in the cumulative
average residuals.
• According to our hypothesis, this implies that on the average the market makes
unbiased dividend forecasts for split securities and these forecasts are fully
reflected in the price of the security by the end of the split month.
Splits and trading profits
• (Do stock prices adjust rapidly to the split information or information implicit in a split? An important
question???) Answer is Yes.
• Is the adjustment so rapid that splits can in no way be used to increase trading profits? Answer is
anomalous
• Firstly, It is clear from Figure 2 that expected returns cannot be increased by purchasing split securities
after the splits have become effective.
• In general, prices of split shares do not tend to rise more rapidly after a split takes place. Of course, if
one is better at predicting which of the split securities are likely to experience "increased" dividends,
one will have higher expected returns. But the higher returns arise from superior information or
analytical talents and not from splits themselves.
• Bellemore and Blucher (1956) conclude that if one has advance knowledge concerning a contemplated
split, it can probably be used to increase expected returns.
• Second, announcement dates have been collected for a random sample of 52 splits from data, the
behavior of the residuals after the announcement date is almost identical to the behavior of the
residuals after the split date. So this indicates that one could not systematically profit from buying split
securities after the effective date of the split, this also suggests that one also cannot profit by buying
after the announcement date however conclusion seems anomalous.
 Does split has effect on investors
decisions?
Figure 4 shows the
cross-sectional mean
absolute deviations of the
residuals for each of the
sixty months surrounding
the split.
From the graph, it is
clear that the variability in
returns on split shares
increases substantially in
the months closest to the
split.
The increased riskiness
of the shares during this
period is certainly a factor
which the investor should
consider in his/her
decisions.
Conclusion
• It is concluded that stock splits, in the past, have very often been associated with substantial
dividend increases. The evidence indicates that the market realizes this and uses the
announcement of a split to re-evaluate the stream of expected income from the shares.
• The evidence indicates that on the average the market's judgments concerning the information
implications of a split are fully reflected in the price of a share at least by the end of the split
month but most probably almost immediately after the announcement date.
• The results of the study lend considerable support to the conclusion that the stock market is
"efficient" in the sense that stock prices adjust very rapidly to new information.
• The evidence suggests that in reacting to a split the market reacts only to its dividend
implications. That is, the split causes price adjustments only ,to the extent that it is associated
with changes in the anticipated level of future dividends.
• Finally, there seems to be no way to use a split to increase one's expected returns, unless, of
course, inside information concerning the split or subsequent dividend behavior is available.