Surprise! Higher Dividends = Higher Earnings Growth

Abstract

We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come.

Since 1995, and until a very recent uptick caused by plunging earnings, marketwide dividend-payout ratios in the United States have been in the lowest historical decile, reaching unprecedented low levels from late-1999 to mid-2001. Alternatively stated, earnings-retention rates have recently been at or near all-time highs. Meanwhile, price-to-earnings ratios and price-to-dividend ratios have been very high by historical standards, even after the sharp fall in stock prices since early 2000. With recent valuation ratios at such high levels and dividend payouts so low, the only way that future long-term equity returns are likely to rival historical norms is if future earnings growth is considerably faster than normal. Some market observers, including some leading Wall Street strategists, do indeed forecast exceptional long-term growth; they point to the recent policy of low dividend-payout ratios, among other things, as a cause for optimism.

Assuming dividend policy does not affect the expected return on the market portfolio, a low payout (dividends/earnings) must be offset either by a high earnings-to price-ratio (low P/E) or by high expected growth. We show that during the past 130 years, market P/Es have not offset variation in payout ratios; for instance, recent P/Es are very high, not low as they would have to be to offset today's low payout. Thus, the task of sustaining return is left to growth.

Some interpret this forecasted marketwide inverse relationship of current dividend-payout policy to future growth as an intertemporal extension of the dividend irrelevance theorem. Implicit in this view is a world of perfect capital markets. For instance, the preceding reasoning assumes that (1) investment policy is unaltered by the amount of dividends paid, (2) information is equal and shared (meaning the dividend does not convey managers' private information), (3) tax treatment is the same for retained or distributed earnings, (4) corporate managers act in the best interests of the shareholders, and (5) markets are priced efficiently. When the assumption of perfection is relaxed, a host of behavioral or information-based hypotheses arise as potential explanations for how the market's payout ratio might relate to expected future earnings growth. Thus, in our study, we turn to the historical data to answer the question of how marketwide payout ratios relate to future earnings growth.

We find that low payout ratios precede low earnings growth and high payout ratios precede high earnings growth. In other words, empirically, real life acts in precisely an opposite manner to what many would forecast. Rather than future growth rising to offset a low payout policy, future growth falls when more earnings are retained.

This finding is consistent with, although other reasons may exist, a world in which managers have private information that they signal through dividend policy; that is, they pay out more when they know that future growth is bright and less when it is dim. The finding also fits a world where managers retain excess cash when they are engaging in inefficient empire building that will hurt future earnings growth. In other words, times of low payout/high retention may be times of wasteful profligacy, and times of high payout/low retention may be times of relative efficiency or frugality. Any explanation of this phenomenon must be considered conjecture, however, at this point.

Applying our results to today's markets, we find little historical support for the contention that future earnings growth will be exceptionally high. Rather, historical evidence on the link between payout ratios and subsequent earnings growth bolsters the view that future earnings growth is likely to be below the long-term average. This outlook is certainly worrisome, particularly because valuation multiples remain well above historical norms.

We would like to thank Peter Bernstein, John Bogle, Sr., Michael Brennan, Christopher Brightman, Edward Chancellor, Peng Chen, Roger Clarke, Brad Cornell, Max Darnell, Russell Fogler, Kenneth French, Roger Ibbotson, Wayne Kozun, Robert Krail, Owen Lamont, John Liew, Tom Philips, Bill Reichenstein, and Rex Sinquefield for very helpful comments and suggestions.