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Does Dividend Policy Foretell Earnings Growth?

Robert D. Arnott

Research Affiliates, LLC

Clifford S. Asness

AQR Capital Management, LLC

December 2001

Many market observers point to the very high fraction of earnings retained (or low dividend payout ratio) among companies today as a sign that future earnings growth will be well above historical norms. This view is sometimes interpreted as an extension of the work of Miller and Modigliani. They proved that, given certain assumptions about market efficiency, dividend policy should not matter to the value of a firm. Extending this concept intertemporally, and to the market as a whole, as many do, whenever market-wide dividend payout ratios are low, higher reinvestment of earnings should lead to faster future aggregate growth.

However, in the real world, many complications exist that could confound the expected inverse relationship between current payouts and future earnings growth. For instance, dividends might signals managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth.

We test whether dividend policy, as we observe in the payout ratio of the market portfolio, forecasts future aggregate earnings growth. This is, in a sense, one test of whether dividend policy "matters." 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 contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is fully consistent with anecdotal tales about managers signaling their earnings expectations through dividends, or engaging in inefficient empire building, at times; either of these phenomena will conform with a positive link between payout ratios and subsequent earnings growth.

Our findings offer a challenge to optimistic market observers who see recent low dividend payouts as a sign of high future earnings growth to come. These observers may prove to be correct, but history provides scant support for their thesis. This challenge is potentially all the more serious, as recent stock prices, relative to earnings, dividends and book values, rely heavily upon this expectation of superior future real earnings growth.

Number of Pages in PDF File: 34

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Date posted: January 7, 2002  

Suggested Citation

Arnott, Robert D. and Asness, Clifford S., Does Dividend Policy Foretell Earnings Growth? (December 2001). Available at SSRN: https://ssrn.com/abstract=295974 or http://dx.doi.org/10.2139/ssrn.295974

Contact Information

Robert D. Arnott
Research Affiliates, LLC ( email )
620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8700 (Phone)
949-325-8901 (Fax)
HOME PAGE: http://www.researchaffiliates.com/Our%20Firm/Our%20Team/Pages/Rob-Arnott.aspx
Cliff S. Asness (Contact Author)
AQR Capital Management, LLC ( email )
Two Greenwich Plaza, 3rd Floor
Greenwich, CT 06830
United States
203-742-3601 (Phone)
203-742-3101 (Fax)
HOME PAGE: http://www.aqrcapital.com

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