Analysts' Use of Dividends in Earnings Forecasts

Abstract

This paper investigates the association between current dividends and analysts’ subsequent earnings forecast errors. This investigation is motivated by the evidence on analyst optimism and Ohlson (1991)’s fundamental valuation theory that dividends displace future permanent earnings. For the sample period 1985-2016, we document, that current dividends are positively correlated with analysts’ future forecast errors, suggesting that analysts potentially ignore the displacement effect of dividends on future earnings. Consistent with theory, this association persists in settings with stable dividends, (i.e., where dividends have limited or no signaling implications) and varies in a predictable manner with dividend payouts and cost of capital. We also find that this empirical regularity that analysts do not fully incorporate the effect of dividends for future earnings, provides opportunities for arbitrage. More interestingly, we find the strength of the association between dividends and analysts’ forecast errors has declined over the sample period; such a decline appears to correspond with the underlying change in the discount rate over time. The finding that analysts’ do not fully incorporate the implications of current dividends on future earnings is consistent with previously documented inefficiencies in analysts’ use of available information. However, such a systematic association also suggests that it may be a source of analysts’ optimistic bias and thus offers new insights into analyst behavior and its persistence over time.

Keywords: Analysts’ Forecast Errors, Analyst Inefficiency, Analysts’ Optimistic Bias, Dividends, Median Regression, Theil-Sen Estimator

JEL Classification: M40, M41, G17, G35