Dividend Payout and Future Earnings Growth

Because dividends reduce the funds available for investment, many market observers and investors associate high dividend payout with weak future earnings growth. Tests using aggregate market data, however, provided evidence that contradicts that view. Because aggregate results may not apply at the company level, we conducted a company-by-company analysis of the relationship between payout and future earnings growth. Our tests also show that high-dividend-payout companies tend to experience strong, not weak, future earnings growth. These results are robust to alternative measures of payout and earnings, sample composition, mean reversion in earnings, the effects of particular industries, time periods, and share repurchases. Market observers and investors often view low dividend payout as a precursor of high future earnings growth. The rationale is that companies pay fewer dividends or retain more earnings when growth opportunities are high. Low payout, in this view, indicates strong future earnings growth. Considerable theoretical and empirical work supports this belief. Others, however, have found in examining the aggregate U.S. equity market that future earnings growth is associated with high rather than low dividend payout, a result that contrasts sharply with conventional wisdom. Although these results for the aggregate market have important implications with respect to the valuation of the overall markets, whether the aggregate-level results pertain also to individual companies has not been determined. We report research to examine that issue. Using company-level data from Compustat, we examined one-, three-, and five-year future earnings growth as a function of dividend payout. In our initial tests, the control variables were company size, return on assets, financial leverage, earnings yield, past earnings growth, and growth in total assets. The large sample included observations from 1950 through 2003. Our tests show that the coefficients on payout are all positive and highly significant, which indicates that companies with high current dividend payouts tend to have high future earnings growth. In tests of robustness, we included controls for the potential effects of survivor bias, potential nonlinearity in the relationship between payout and future earnings growth, alternative measures of earnings, small companies, regulated industries, specific time periods, industry membership, and share repurchases. The relationship between dividend payment and high future earnings growth remained strong. What explains the positive relationship between current payout and future earnings growth? A possibility is that the companies with low dividend payouts are overinvesting free cash flow. To test for the operation of this free cash flow theory, we adopted as a proxy for growth opportunities the ratio of a company’s market value of equity and book value of debt to the book value of its assets,V/A. We found that the relationship between payout and future earnings growth continued to be strong despite the introduction of theV/A variable. These results indicate that when growth potential is low, the association between payout and earnings growth is strong, a relationship that is consistent with the overinvestment of free cash flow. Our company-level analysis complements the previous aggregate-level analysis that found that high payout is related to high future earnings growth. And both studies challenge conventional wisdom. The previous study is important for valuing the aggregate markets; our results shed light on the valuation of individual stocks.