Dividend Payout Prediction using

Discriminant Analysis

IQRA University
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Prepared by:
Hafiz Muhammad Iqbal
10279
MBA (Morning)
Quantitative Techniques in Data Analysis

Submitted to:
Dr. Basheer Ahmad Samim
Date:
2nd August, 2010
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Abstract

This study aims to recognize the significance of financial information as to be the reflection of a
firm’s financial performance. The purpose of this study is to test the predictive ability of financial
ratios regarding whether the firm is intending to pay the dividends to its shareholders or not. The
discriminant technique is applied to test the ability of the financial information, using the data of
the firms operating in chemical sector of Pakistan from 2005-06 to 2008-09. The data has been
collected from the official website of Karachi Stock Exchange. The outcome of this study enables
those shareholders who are dividend oriented, in deciding, in which stock they should invest so as
to obtain the maximum return in the form of dividend002E
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Table of Contents

Introduction………………………………………………………..5

Literature Review……………………………………………..……6

Description of the data file………………………………………..11

Problem description……………………………………………....12

Application of technique………………………………………….13

Results………………………….………………………………….17

Recommendations……………………………………………...…17

Conclusions……………………………………………………….17

Appendix………………………………………………………….18
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Introduction
In recent years many successful applications of Multiple Discriminant Analysis have been
reported. Some of the more interesting efforts involve prediction of industrial bond ratings,
prediction of corporate bankruptcies, identification of conglomerate targets, and description of
common stock price variability. MDA is a multivariate statistical tool that allows the analyst to
classify subjects or observations (firms in this study) into appropriate a priori groups (firms that
issued either bonds or common stocks). For the two group case, MDA reduces the task of
examining group differences among a large number of descriptor variables to a univariate problem.
The calculated multiple discriminant function, then can be used to simultaneously distinguish
between subject classes on the basis of multiple independent variables. For predictive purposes the
essential output from the MDA technique is a linear equation referred to as the discriminant
function and is of the form:

Zi = VXli + V2X2i + ...+ VnXni,

Where Zi is the ith observation's discriminant score, Vj is the discriminant coefficient for
the jth variable, and Xji is the ith observation's value of the jth independent variable. In the two
group case, if Zi exceeds some critical value of Z, the ith observation belongs to group one (e.g.,
firm's issuing bonds); if Zi is less than the critical Z, the observation belongs to group two (e.g.,
firm's issuing common stock).

The null hypothesis is that the two or more group means are equal on the discriminant
function(s), thus a significant model would indicate that the group means are not equal. Its
assumptions are:

1. All the predictors are normally distributed.

2. The mean and variance of predictors are not correlated.
3. The predictors are not highly correlated with each other.
4. The correlation between two predictors is constant across the groups.

The analysis results in calculating classification coefficient for each variable which can
discriminate between the groups. The classification table gives the number of correctly classified
cases which gives us the Hit Ratio of the test.
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Literature Review

Summary 1: Financial Differences between Large and Small Firms

In essence, the research question is: Does the financial management of the small publicly-owned
business result in distinctively different financial characteristics from those of its larger publicly-
owned counterpart. The financial management of the small business often may be dictated by the
restricted choices available to it, such as fewer options for investing excess liquidity. They suggest
that one possible indicator of such a phenomenon is the disparity between costs of equity funds for
smaller and larger firms. Random samples were gathered of both small and large manufacturing
concerns in order to make the proposed comparison of financial characteristics between large and
small companies. To be classified as "small," an operation must have had less than $5 million in
total assets. Compustat used the data base for sampling large companies, with the only constraint
placed upon the random selection process of these larger businesses being the similarity of
industry classifications with the small firms. Given the number of variables and the validation
technique to be employed, a total sample size of 62 firms seemed sufficient, 31 large, 31 small.

The analysis considers five basic dimensions of the financial operations of a business. They
include an examination of corporate liquidity, profitability, financial leverage, business risk, and
dividend policy. Differences between groups are usually identified by a statistical test being
performed upon descriptive variables, discriminant analysis, a multivariate technique for testing
for group differences, offers a constructive tool. Finally, interdependence among variables may
bias the results. The groupings in the current study, "small" and "large" corporations, do not
completely satisfy the first assumption. Size is a continuous variable, but because interest of
researcher was restricted to two extreme firm classes, that of large entities and small publicly-held
firms, the discontinuity in the size variable makes discriminant analysis appropriate.

The test results show a clear distinction between the financial characteristics of large and small
corporations. 83.87% of the small firms and 80.64% of the large firms are classified correctly, for
an overall probability of 82.25% correct classification. The dissimilarities in dividend policy are
seen to be the leading factor in discriminating between the two classifications. In view of the
average percentage of earnings paid by small and large operations, that being 3% and 40%,
respectively, the strength of the variable is certainly not surprising. The second determinant of
importance in distinguishing between the groups is relative liquidity position. Large corporations
have more liquidity, as reflected by the current ratio. A third distinguishing variable is profitability.
The smaller growth firm is better at generating earnings than the large companies. This research
has only identified the "symptoms" of these differences.
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Summary2: A Discriminant Function for Earnings-Price Ratios of Large Industrial Corporations

The intent of this study is to ascertain that linear combination of financial characteristics which
best discriminates large industrial corporations with low ratios of earnings per share to common
stock price from those with high ratios.

The proposition which underlies the division of firms into high and low ratio groups is that, if
allowance is made for the historical nature of earnings and for market imperfections, the earnings-
to-stock-price ratio reflects the composite market valuation of such factors as financial risk and
dividend policy. Discriminating variables, that is, financial characteristics chosen to reflect
individual elements of risk and other factors which affect e/p ratios, include the ratio of dividends
to earnings, the ratio of current assets to current liabilities, the rate of return on additional
investment, the relative change in sales, and the comparative stability of the common stock price.

First, procedures for the selection of under- and overvalued stocks may be improved by the
introduction of discriminant analysis. If the discriminating index suggests that a firm clearly
belongs to one group while its e/p ratio indicates otherwise, some reason exists for believing the
company's stock to be under- or overpriced. Second, partial conclusions may be drawn as to the
influence of changing stock market levels upon the importance of different factors which condition
e/p ratios. Third, the argument for accepting e/p ratios as "givens" in the corporate investment
decision process may be lessened. Differentiation between low- and high-risk firms son the basis
of measurable financial characteristics may facilitate the modification of these characteristics to
alter the risk classification.

The ordering of the discussion is as follows: The population from which the sample is drawn is
described and the operation on the data indicated; the linear discriminant function, based upon
1952-55 data, is set forth and evaluated; the discriminant function is then applied to 1948-51 data;
and, finally, simple regressions are introduced to test the similarity of industry patterns.

Utilization of the I948-5I data for the sample of sixty firms whose mean values are given above
produces the following relation: z = X1 + .38IX2 - .005X3 + .773X4 + .022X5 + .38IX6.

The results of this study suggest that firms with low e/p ratios can be differentiated from those with
high ratios on the basis of financial characteristics. The linear discriminant function derived from
I952-55 data tends to classify corporations properly even when applied to I948-5I data. The post-
I95I behavior of misclassified companies indicates, moreover, that inconsistencies between z
ratings and e/p ratios often diminish over time. Whether the number and character of the
discriminating variables warrant adjustment, remains in doubt. Of the variables used, dividend
payout (X1) and stability of common stock prize (X6) are assigned the greatest weights. The
remaining variables are less clearly differentiated between groups.
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Summary 3: Corporate Stock Issue and Repurchase

The primary purpose here is to identify the characteristics of firms engaged in stock issue or
repurchase activity. All direct changes caused by the decision of management to increase or reduce
the outstanding equity capitalization of the firm are explicitly considered in this study.
Management has 3 alternatives. It can issue new stock, either directly or indirectly (warrants,
convertibles, etc.); buy back already outstanding stock through open market purchases or tender
offers; or, finally, do nothing. Only the first two alternatives are considered in this study. Other
numerous studies include those by Ellis and Young [2] on the repurchase decision and Robichek
and Myers [7] on the choice between debt and equity.
All of the NYSE firms whose financial and accounting information are on the COMPUSTAT tapes
for the period 1967-72 were used in generating a company information file. Exclusion of firms
which had a substantial amount of missing or erroneous data resulted in a final sample of 1,043
firms. A cross-sectional sample of them was manipulated into 49 variables for the company in-
formation file. With some exceptions and variations, the basic types of variables and the
calculation procedures were modeled after those used by Pinches and Mingo [6]. The types were:
(1) standard financial ratios and accounting information for 1972; (2) 5 year means for these ratios;
(3) coefficients of variation for these ratios; and (4) others.

In generating the factor analysis/multiple discriminant analysis model, a part of the Michigan
Interactive Data Analysis System was used to normalize and standardize the company data to
insure that the data requirements for these analyses were met. An initial data reduction was then
performed by means of Correlegram Analysis. That is, the correlation matrix of the original data
set was examined to identify the most related variables. By eliminating the unimportant
independent variables, a reduction in the number of factors identified by the factor analysis is
assumed. As a rule of thumb, any variable with a correlation coefficient greater than .400 with any
other variable is retained in the sample
The analysis presented identified the cross-sectional characteristics of repurchasing and issuing
firms. Firms that issued during 1972 were characterized by higher leverage and smaller dividends,
which indicate that relative to the repurchasing companies the issuers, need additional funds. The
alternatives corporations use in obtaining funds in order of least to most expensive are issuing
debt, retaining earnings and issuing new stock. The results of this study suggest that corporate
issuers exhausted their debt capacity (high leverage) and retained a lot of earnings (low dividends),
and so were using the next best, albeit most expensive, means of generating additional capital for
investment. The repurchasing firms appear to be in a position of excessive liquidity. They have
low leverage, an indication of unused debt capacity. They have relatively higher dividends, which,
ceteris paribus, suggest lower retained earnings.
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Summary 4: A Discriminant Analysis of the Corporate Debt-Equity Decision

In this paper profiles of a sample of debt and equity-issuing firms are described and utilized to address
the choice between new debt and equity. While the debt-equity question is not simple and the
debt/equity mix may be properly viewed as a continuous variable ranging from very heavy leverage use
to exclusively common equity, in this analysis it Winter 1974 71 is assumed that the firm, possibly
operating in response to an established policy, has already decided to sell either new bonds or new
common stock.
The underlying hypothesis here is that companies choosing to issue debt instead of common equity (or
vice-versa) possess distinctive financial characteristics
Specifically, multiple discriminant analysis (MDA) is used to derive a model, based on the
characteristics and decisions of a group of firms, useful in decision making by other firms.
In formulating debt-equity decisions firms might reasonably be expected to consider the seven general
financial condition areas of leverage, liquidity, profitability, dividends, market price, firm size, and sales
growth and variability. A brief discussion of why these particular aspects should be considered follows.
The ratios and statistics chosen as reflective of these dimensions are defined in the inset.
A linear discriminant function that distinguishes between the two types of companies on the basis of
financial characteristics is estimated using data associated with a sample of industrial firms that publicly
issued either debt or common stock during 1971.
Descriptions (special tables section) for the years 1971-72. The original sample involves 112 firms of
which 62 issued debts and 50 issued common stock; the hold-out sample includes 33 debt-issuing and 25
equity-issuing companies.
To test the discriminatory power of the calculated function, each sample firm is classified into either the
debt- or equity-issuing group on the basis of each observation's discriminant score. A classification
matrix based on the original sample of 112 companies, which shows that 49 of the 62 firms issuing
bonds were correctly classified by the model, while of the 50 firms that issued common stock, 35 were
properly classified. Over-all the model assigned 75% of the original sample companies to the
appropriate groups.
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Summary 5: Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy

The purpose of this paper is to attempt an assessment of this issue-the quality of ratio analysis as
an analytical technique. The prediction of corporate bankruptcy is used as an illustrative case.'
Specifically, a set of financial and economic ratios will be investigated in a bankruptcy prediction
context wherein a multiple discriminant statistical methodology is employed. The data used in the
study are limited to manufacturing corporations

In general, ratios measuring profitability, liquidity, and solvency prevailed as the most significant
indicators. The order of their importance is not clear since almost every study cited a different ratio
as being the most effective indication of impending problems.

A multiple discriminant analysis (MDA) was chosen as the appropriate statistical technique.

MDA is a statistical technique used to classify an observation into one of several a priori groupings
dependent upon the observation's individual characteristics. It is used primarily to classify and/or
make predictions in problems where the dependent variable appears in qualitative form, e.g., male
or female, bankrupt or non-bankrupt. Therefore, the first step is to establish explicit group
classifications. The number of original groups can be two or more.

The discriminant function of the form Z = vXI + V2 X2 +. . . + Vn Xn transforms individual

variable values to a single discriminant score or Z value which is then used to classify the object

where v1,v 2, ... vn= Discriminant coefficients

x1, x2, . . . xn=Independent variables

The MDA computes the discriminant coefficients, vj, while the independent variables xj are the
actual values where ,j=1, 2,... n.

The initial sample is composed of sixty-six corporations with thirty-three firms in each of the two
groups. The bankrupt groups (1) are manufacturers that filed a bankruptcy petition under Chapter
X of the National Bankruptcy Act during the period 1946-1965. Recognizing that this group is not
completely homogeneous, due to industry and size differences, a careful selection of non-bankrupt
firms was attempted. Group 2 consisted of a paired sample of manufacturing firms chosen on a
stratified random basis. The firms are stratified by industry and by size.

The discriminant-ratio model proved to be extremely accurate in predicting bankruptcy correctly in

94 percent of the initial sample with 95 per cent of all firms in the bankrupt and non-bankrupt
groups assigned to their actual group classification.
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Description of the Data File

The data file contains the financial ratios of various firms of chemical sector of Pakistan. The data
includes financial information of 5 years from 2005-06 to 2008-09. Due to recession of 2009 and
Stock Market slump of 2008, many companies underwent bankrupt and at the same time many
new companies incorporated, as a result all the companies are included in the analysis irrespective
of whether they exist in a single year or in all five years. 20 variables are included in the data file
out of which 4 variables are used in the analysis. 79 cases are reported out of which 65 cases are
used for prediction of remaining 14 cases. 65 cases are further divided into 70% analysis sample
for model estimation and 30% holdout sample for validation.

Following 4 variables are used in the analysis:

1. Earnings Per Share (Independent Scale Variable)

2. Net Profit Margin Ratio (Independent Scale Variable)
3. Debt to Equity Ratio (Independent Scale Variable)
4. Dividend Paid (Dependent Categorical Variable)
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Problem Description
Investors are very conscious regarding the amount of investments that they make. Investors who
make their investments in shares anticipate their return either in the form of Capital Gain or
Dividend or both. Capital Gain is considered to be volatile and it keeps changing with the
fluctuations in the stock prices. On the other hand, Dividends tend to remain consistent and stable,
so for those investors who are risk averse, they follow return in the form of dividend. This study
assists those shareholders who want to purchase shares to earn the returns in the form of dividend,
as they will be more interested to invest in those stocks which have the tendency to pay dividends
in future based on current financial information.

When deciding whether to pay the dividends or not, board of directors consider various
elements of varying importance in order to reach at final decision. They give a comprehensive
sight to these factors which consolidate their dividend payout decision. The factors might include
legal requirements, firm’s internal constraints etc. Apart from those factors, directors also take into
account the financial performance and position of the firm in order to assess as whether on
financial grounds, firm is capable of paying out dividends or not. Those financial factors are
reflected by some financial ratios. For dividend payout decisions, boards of directors are mainly
interested in profitability, leverage and liquidity ratios. If these ratios are significant enough then
they look forward for further considerations regarding dividend payout decision.

Discriminant Analysis is the technique which is used to test the predictive ability of
whether the firm is intending to pay dividend or not. This statistical technique will differentiate
those stocks which are going to pay dividend, from those stocks which are not going to pay
dividends.
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Application of Technique
Multiple Discriminant Analysis is applied to address the problem statement. The dependent
variable is a categorical variable of Dividend having two categories i.e. Yes and No. The
independent variables are the 3 financial ratios used as predictors in this model.

The variables are included in the analysis with enter method, and the co-variance matrix across the
group is calculated from within groups. The prior probabilities are taken from the group sizes, as it
is assumed that the groups in the population are not equal. When the results are obtained including
all variables, Earning Per Share resulted in a significant variable whereas Net Profit Margin turned
out to be insignificant variable. Debt to Equity variable has a p-value closer to 0.05, thus, it is
assumed to be a significant variable.

Tests of Equality of Group Means

Wilks' Lambda F df1 df2 Sig.

Earnings Per Share .676 21.594 1 45 .000

Net Profit Margin Ratio .998 .088 1 45 .768

Debt to Equity Ratio .918 4.027 1 45 .051

Eigen values

Function Eigen value % of Variance Cumulative % Canonical Correlation

1 .522a 100.0 100.0 .586

a. First 1 canonical discriminant functions were used in the analysis.

The above table tells us that the function calculated is explaining the 100% variance of the model.
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Wilks' Lambda

Test of
Function(s) Wilks' Lambda Chi-square df Sig.

1 .657 18.265 3 .000

This table tells us that how much discriminatory power does the function has. It is significant
because the sig value is less than 0.05. Smaller Wilks’ Lambda value indicates that the function
has strong discriminating power.

Test Results

Box's M 144.508

F Approx. 22.325

df1 6

df2 13999.898

Sig. .000

Tests null hypothesis of equal

population covariance matrices.

The Box’s M test for the equality of covariance matrix is accepted which means that the
covariance is constant across the groups.
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Classification Function Coefficients

Dividend Paid

Yes No

Earnings Per Share .226 .070

Net Profit Margin Ratio 3.126 3.545

Debt to Equity Ratio 15.216 17.172

(Constant) -6.345 -6.962

Fisher's linear discriminant functions

The discriminant functions coefficients are given in the table above:

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Classification Resultsb,c,d

Predicted Group Membership

Dividend Paid Total
Yes No

Yes 16 9 25
Count
No 1 21 22
Original
Yes 64.0 36.0 100.0
%
No 4.5 95.5 100.0
Cases Selected
Yes 15 10 25
Count
No 3 19 22
Cross-validateda
Yes 60.0 40.0 100.0
%
No 13.6 86.4 100.0

Yes 9 3 12

Count No 0 6 6

Ungrouped cases 6 8 14
Cases Not Selected Original
Yes 75.0 25.0 100.0

% No .0 100.0 100.0

Ungrouped cases 42.9 57.1 100.0

a. Cross validation is done only for those cases in the analysis. In cross validation, each case is classified by the
functions derived from all cases other than that case.

b. 78.7% of selected original grouped cases correctly classified.

c. 83.3% of unselected original grouped cases correctly classified.

d. 72.3% of selected cross-validated grouped cases correctly classified.

The classification results show that 78.7% of the cases were correctly classified using the three
ratios as the predictors.
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Results
Dividend ( having categories Yes and No) is used as dependent variable and 3 financial ratios were
used as independent variable in order to find whether they can discriminate between dividends
paid or not categories. Following are the results of Discriminant Analysis:

1. 78.7% of selected original grouped cases correctly classified.

2. 83.3% of unselected original grouped cases correctly classified.
3. 72.3% of selected cross-validated grouped cases correctly classified.

Recommendation
The analysis revealed that Earnings per Share and Debt to Equity ratios are the real predictors of
dividend prediction whereas Net Profit Margin is not the true predictor of dividend decision.
Therefore investors should significantly investigate Earnings per Share before investing in any
stock if they are dividend oriented and afterwards they should take into account the firm’s debt to
Equity ratio and other ratios.

Conclusion
This study showed some significant findings as Dividend Payout Decision can mainly be predicted
by Earnings per Share and firm’s Debt to Equity ratio. However, directors also consider some
other qualitative factors which enable them to reach at the ultimate of decision regarding dividend
payout. Hence, from investors’ point of view, Earning per Share is the most significant factor
which must be taken into account before taking any investing decision.
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Appendix

Source of the data:

The data was obtained from official website of Karachi Stock Exchange.

Other tables in the analysis:

Structure Matrix

Function

Earnings Per Share .959

Debt to Equity Ratio -.414

Net Profit Margin Ratio .061

Pooled within-groups correlations between

discriminating variables and standardized
canonical discriminant functions
Variables ordered by absolute size of
correlation within function.
The above matrix gives the correlation of each predictor with the discriminant function. These are
also called discriminant loadings.

Functions at Group Centroids

Function
Dividend Paid
1

Yes .663

No -.753

Unstandardized canonical discriminant functions evaluated at group

This table gives means the groups’

centroids.
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Prior Probabilities for Groups

Cases Used in Analysis

Dividend Paid Prior
Unweighted Weighted

Yes .532 25 25.000

No .468 22 22.000

Total 1.000 47 47.000

The above table tells us that the group probabilities are calculated from the group size as both the
probabilities for each group are not same.