Dividend changes and information about future profitability: an application of difference GMM

Abstract

This research examines whether dividend changes convey information about future profitability. The difference GMM approach is employed to overcome the heterogeneity and endogeneity problems inherent in dynamic panel data models. Our evidence shows that previous abnormal earnings are a good predictor for subsequent abnormal earnings. Other than previous abnormal earnings, only dividend increases are strongly related to future profitability. Subsequent to dividend increases, profitability can last for four years. On the other hand, dividend decreases, initiations and omissions tend to reflect only concurrent profit performance. It is possible that previous abnormal earnings convey the most information about subsequent profitability, undermining the signalling of the dividend changes.

Keywords:

• dividend changes
• profitability
• difference GMM
• endogeneity

JEL Classification:

• G35
• C23

Notes

¹ See Benartzi et al. (1997), Nissim and Ziv (2001), Grullon et al. (2005), and many others.

² GTSM is the OTC market in Taiwan.

³ The cost of equity capital is estimated as the annualized return of one-month Treasury bills plus equity risk premium at the beginning of the year. Sincere thanks to Professor Aswath Damodaran for generously providing the risk premium data on his website.

⁴ The instrument variables include level instruments, AE_i,t–2, DIC_i,−2 × ∆Div_i,–2, DDC_i,–2 × ∆Div_i,–2, DIT_i,–2 × ∆Div_i,–2 and DOM_i,–2 × ∆Div_i,–2, and transformed instruments, first-differenced ME_i,–1 and TA_i,–1.