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7/28/2019 Are Future Earnings Related to Past Earnings Performance and Dividend.pdf
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7/28/2019 Are Future Earnings Related to Past Earnings Performance and Dividend.pdf
2/33Electronic copy available at: http://ssrn.com/abstract=1782122
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Are Future Earnings Related to Past Earnings Changes and DividendChanges?
Evidence on the view that dividend changes are directly related to future earnings growth
is mixed. 1 More recent empirical studies suggest that dividend changes are actually managerial
signals about the permanence of earnings changes that have already occurred; an idea alluded
to by Lintner (1956) in his survey (for convenience, we refer to this as the permanence
hypothesis). DeAngelo et al. (1992) document more persistent losses for firms that reduce
dividends than those that maintain their dividends. Benartzi et al. (1997) report that increases
in earnings are more permanent for the firms that subsequently increase their dividends than
those that maintain theirs.
Related studies investigate whether investors view dividend-change news as managerial
private information about the permanence of prior earnings changes. Kane, Lee and Marcus
(1984) find that investors give more credence to dividend changes that are in the same
direction as prior earnings changes (corroboratory dividend changes). Koch and Sun (2004)
reason that, if investors view dividend changes as signals about the permanence of prior
earnings changes, dividend-change announcement returns should be related to the magnitude
of the past earnings changes. For instance, a dividend increase that signals that a large increase
in earnings is permanent should induce a larger positive market reaction than a dividend
increase that signals that a small increase in earnings is permanent. Similar arguments apply to
dividend reductions after earnings declines, suggesting confirmatory dividend-change
announcement returns should be directly related to the magnitude of the past earnings changes.
1 Some of the studies that support this view include Brickley (1983), Healy and Palepu (1988), DeAngelo,DeAngelo and Skinner (1992), Aharony and Dotan (1994), and Nissim and Ziv (2001), while those that refute itinclude Watts (1973), Gonedes (1978), Penman (1983), Benartzi et al. (1997), and Grullon et al. (2005).
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In contrast, contradictory dividend-change announcement returns should be inversely related to
the magnitude of the prior earnings changes. Koch and Sun (2004) find support for these
predictions. If dividend changes are managerial private information about the persistence of
prior earnings changes, as the market seems to suggest, we can predict the future earnings
patterns contingent on the sign of the prior earnings changes and dividend changes. We
develop and test these future earnings implications of the permanence hypothesis, and our
results support it.
Very few studies condition the relation between dividend changes and changes in future
earnings on past earnings performance. DeAngelo et al. (1992) and DeAngelo et al. (1996)examine NYSE-listed firms that sustain losses after long periods of continuous positive net
income and Benartzi et al. (1997) focus on firms whose dividend increases confirm their past
earnings increases. Our paper extends Benartzi et al. (1997) to include the complete menu
presented by the permanence hypothesis: (i) earnings increases followed by dividend increases
or reductions and (ii) earnings decreases followed by dividend increases or reductions. 2 This
has become important in light of Koch and Suns (2004) finding that market reactions to
dividend-changing news are consistent with the view that dividend changes (not only
confirmatory dividend increases) are managerial private information about the permanence of
prior earnings changes. Thus, we test whether future earnings patterns are consistent with the
permanence hypothesis as well as its supporting evidence from the markets reaction to
dividend changes.
Benartzi et al. (1997) suggest that dividend increases that follow earnings increases are
managerial private signals that the higher earnings are permanent. If one extrapolates this to
2 While a limited number of data points for some of the cases made testing all four possible scenarios problematicin the past, we believe that current data are sufficient to test all four cases. This will allow a more robustconclusion to be reached on the permanence hypothesis.
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dividend reductions that follow earnings increases, then these dividend reductions are signals
that the higher earnings are not permanent. Consequently, after an increase in earnings, a
dividend increase is a managerial signal that the higher earnings are permanent, while a
dividend reduction suggests the higher earnings are not permanent, and an unchanged dividend
conveys no information regarding earnings permanence. Accordingly, higher earnings should
be more (less) permanent for the firms that subsequently increase (decrease) their dividends
than their counterparts that maintain their dividends.
Turning to firms with declines in prior earnings, the permanence hypothesis suggests that
dividend reductions are managerial signals that the lower earnings are permanent. If dividendreductions after earnings declines are signals that the lower earnings are permanent, then
dividend increases after declines in earnings are managerial private information that the lower
earnings are temporary. As a result, lower earnings should be more (less) permanent for the
firms that reduce (increase) their dividends than those that maintain theirs. Thus, the
permanence hypothesis indicates that the relation between dividend changes and future
earnings is governed by the sign of the prior earnings change. For instance, a dividend increase
after an increase in earnings signals that the higher earnings is permanent, while the same
dividend increase after a decline in earnings signals that the lower earnings is temporary,
indicating growth in future earnings.
To test these hypotheses, we classify all dividend payers by the sign of their earnings
changes and by their dividend changes, and study the behavior of future earnings these groups.
Our results show that confirmatory dividend changes are signals that the prior earnings changes
are permanent. In particular, as in Benartzi et al. (1997), we find that increases in prior
earnings are less likely to reverse for firms that subsequently increase dividends than those that
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maintain their dividends. In addition, we find that declines in prior earnings persist more for
the firms that subsequently reduce their dividends than those that leave their dividends
unchanged. 3
Turning to firms with contradictory dividend changes, our results show that declines in
earnings tend to reverse more among firms that subsequently increase their dividends than
those that maintain theirs as the permanence hypothesis predicts. This suggests that managers
do not only increase dividends based on increases in past earnings, they also increase dividends
in anticipation of future earnings increases, especially when their expectation is contradicted by
the current earnings performance. This is consistent with the models of Bhattacharya (1979)and Miller and Rock (1985), which suggest that managers change dividends to convey
information about future earnings in the presence of information asymmetry.
In contrast to the permanence hypothesis, we do not find that increases in earnings
reverse more firms that subsequently reduce dividends than those that maintain their dividends.
It is well-established that managers dislike dividend reductions due to the associated negative
market reactions. Given the reluctance to reduce dividends and the fact that prior earnings
increased, it does not appear that contradictory dividend reductions are motivated expectations
that the higher earnings will reverse. Thus, unlike contradictory dividend increases, where it is
conceivable that anticipation of reversals in declined earnings can drive increases in dividends,
it difficult to understand why dividend-reduction-averse managers would reduce dividends in
anticipation of reversals in increases in current earnings.
The relatively strong performance of the firms with contradictory dividend reductions in
the prior and subsequent quarters led us to study the capital expenditure patterns of our sample
3 This is in line with DeAngelo et al. (1992) finding that losses are more permanent for firms that reduce their dividends than those that maintain theirs.
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firms. The results show that firms with contradictory dividend increases increase their capital
expenditures the most. This suggests that dividend reductions following increases in earnings
are, at least partly, motivated by cash needs to boost investment. Thus, with the exception of
contradictory dividend increases, the evidence from future earnings behavior is exactly as the
permanence hypothesis predicts. Overall, therefore, we find support the hypothesis that
dividend changes are managerial signals about the persistence in past earnings changes.
Our results make two important contributions to the empirical literature on the
information content of dividend changes. First, our paper extends Benartzis et al. (1997)
findings that confirmatory dividend increases are signals that the higher earnings will notreverse in future. Specifically, we find that confirmatory dividend reductions are signals that
the lower earnings will not reverse, and contradictory dividend increases are signals that the
lower earnings will reverse. Second, our result shows that dividend changes do not only help
investors update their assessments of the persistence in past earnings changes (Koch and Sun
(2004)), but they also predict future earnings patterns conditional on the sign of the prior
earnings change. That is, the future earnings patterns are consistent with investors
interpretations of dividend changes given the sign of the prior earnings change.
The rest of the paper is organized as follows: Section I summaries the related literature
and develops the testable hypotheses; Section II presents the data and initial evidence; Section
III discusses the results; Section IV explores the robustness; and Section V concludes.
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I. Related Literature and Testable Hypotheses
Lintners (1956) influential study of dividend policy suggests that firms increase
dividends when management believes that earnings have permanently increased. Subsequently,
Miller and Modigliani (1961), Bhattacharya (1979), Miller and Rock (1985), and John and
Williams (1985) theorize that dividend changes can also convey information about future cash
flow when markets are incomplete or when there is information asymmetry. These models
point to a direct relation between dividend changes and future earnings. To empirically
investigate this prediction, Watts (1973) regresses next years earnings on this years dividend
changes and obtains positive but insignificant coefficient estimates. Subsequent studies byGonedes (1978), Penman (1983), Jensen et al. (2010) report similar results. Also, Healy and
Palepu (1988) report that the earnings of firms that omit dividends do not decline in the
following years, but rather increase. These studies, therefore, do not support the notion that
dividend changes are directly related to future earnings changes.
In line with a direct relation, Healy and Palepu (1988) report that earnings of dividend
initiators increase in the two years after the initiations. Brickley (1983) also report the earnings
increase after large dividend increases (of more than 20%). Aharony and Dotan (1994)
document earnings increases in the four quarters after dividend increases. After using several
different measures of earnings, Benartzi et al. (1997) they find that dividend changes are not
directly related to future earnings. Nissim and Ziv (2001) counter that dividend changes are
directly related to future earnings changes after controlling for linear mean revisions in
earnings. Grullon et al. (2005) suggest that dividend changes are not directly linked to future
earnings changes after adjusting for nonlinear patterns in earnings. Collectively, the evidence
in support of a direct link between dividend changes and future earnings changes is weak.
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Not finding a direct relation between dividend changes and future earnings changes,
Benartzi et al. (1997) test Lintners (1956) finding that dividend increases signal permanence
of past earnings increases. Specifically, they analyze firms with similar past earnings increases
and find that the higher earnings are less likely to reverse for those that increase their
subsequent dividends than those that maintain theirs. 4 Thus, the authors conclude that
corroboratory dividend increases are signals that the increases in earnings are permanent.
Koch and Sun (2004) study whether the market views dividend changes as managerial
information about the permanence of prior earnings changes. They argue that, if the market
interprets dividend changes as such, corroboratory dividend-change announcement returns will be directly related to prior earnings changes while contradictory dividend-change
announcement returns will be inversely related to prior earnings changes. With the exception
of contradictory dividend increases, Koch and Sun find that investors interpret dividend
changes as providing managerial information about the permanence of earnings changes that
have already occurred. Are these investors interpretations correct in the face of future earnings
changes? We study the evolution of earnings contingent of past earnings performance and
dividend changes to address this question.
Both the permanence hypothesis and its supporting evidence from the markets reactions
to dividend changes (Koch and Sun (2004)) have clear implications for future earnings pattern.
Specifically, they both suggest that increases in earnings should exhibit more permanence
among firms that subsequently increase dividends but exhibit more reversal among those that
subsequently reduce their dividends compared to the firms that leave their dividends
4 Other studies that condition the relation between dividend changes and future earnings on past performanceinclude DeAngelo et al. (1992) who studied NYSE-listed dividend payers that reported positive earnings in eachof the ten years prior to annual losses and find that the losses tend to be more permanent for those that decreasetheir dividends than those that maintain theirs, while DeAngelo et al. (1996) find that dividend increases by suchfirms do not convey any information about the permanence of their current earnings problems.
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unchanged. Likewise, following declines in earnings, firms that reduce (increase) dividends
should display more persistence (reversal) in their lower earnings than those that maintain their
dividends. Thus, if Y0,T denotes the change in earnings from the current period to future
period T, then following increases in earnings, Y0,T should on average be higher for the firms
that subsequently increase dividends than those that maintain their dividends, and these firms
should, in turn, have higher average Y0,T than those that reduce their dividends. Similarly,
after declines in earnings, Y0,T should be higher (lower) on average for the firms that
subsequently increase (reduce) their dividends than those that maintain their dividends.
Accordingly, we test the following hypotheses:(H1): Following earnings increases, Y0,T is on average higher for the firms that increase
their subsequent dividends than those that leave their dividends unchanged.
(H2): Following earnings increases, Y0,T is on average lower for the firms that reduce
their subsequent dividends than those that leave their dividends unchanged.
(H3): Following earnings increases, Y0,T is on average higher for the firms that increase
their subsequent dividends than those that reduce their dividends.
(H4): Following earnings declines, Y0,T is on average higher for the firms that increase
their subsequent dividends than those that leave their dividends unchanged.
(H5): Following earnings declines, Y0,T is on average lower for the firms that reduce
their subsequent dividends than those that leave their dividends unchanged.
(H6): Following earnings declines, Y0,T is on average higher for the firms that increase
their subsequent dividends than those that reduce their dividends.
Throughout our paper, we test the difference in the average Y0,T for our portfolios based
on t-tests of the mean differences and Wilcoxons test of the median differences.
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II. Data and Evidence
A. Variable Definitions
The two main variables of interest are dividend changes and earnings changes. We measure
change in dividend as 1,1,0,0, /)( iiii D D D D , where D i,t is firm is dividend in quarter t .
Measuring changes in earnings is tricky as different models of expected earnings deliver
different measures. We initially measure the change in prior earnings as the scaled change in
earnings in the most recent four quarters over the preceding four quarters, adjusted for the four-
year earnings drift (prior studies document drift in earnings; e.g., Foster (1977)).5
Thus, the
change in earnings for firm i in quarter 0 is computed as:
, /)4/)()((*100 0,23,20,7,4,7,4,3,0,0, iiiiii BE E E E E Y
where E i,t,x is the sum of firm is earnings from quarter t to quarter x and BE i,t is the firms book
value of common equity at the end of quarter t . Like Nissim and Ziv (2001), book values of
equity that are less than 10% of the firms total assets are set to 10% of the total assets to
minimize distortions from the deflation (this affects .8% of our sample). In addition, we
winsorize changes in earnings at 1% to minimize outlier effects.
Similar to previous studies, we focus on analyzing the changes in earnings in the four
and the eight quarters following the quarters for which the dividends were announced. These
are computed as :
./)4/)()((*100
and
/)4/)()((*100
0,19,16,3,0,3,0,5,8,2,
0,19,16,3,0,3,0,1,4,1,
iiiiii
iiiiii
BE E E E E Y
BE E E E E Y
5 Adjusting for the three-year or five-year drift does not affect our qualitative results.
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We measure the future earnings changes with respect to the same benchmark ( E i,0,-3 ) as the
permanence hypothesis is about whether the change in current earnings will reverse in the
future or not. Furthermore, gauging the change in future earnings with respect to the same
benchmark minimizes the problems with measuring earnings changes discussed in Nissim and
Niv (2001). Thus, we compute the average of Y i,1 and of Y i,2 for each of our portfolio of
firms, and test the differences in these averages to test hypotheses (H1) through (H6).
B. Sample Selection
We extract data for New York Stock Exchange (NYSE), American Stock Exchange(AMEX), and NASDAQ listed common stocks that have dividend information in the Center
for Research in Security Prices (CRSP) database and have quarterly earnings before
extraordinary items (Data No. 8) in the COMPUSTAT database. Our sample covers January
1979 through December 2009 and to remain in the sample in a quarter, a firm must meet the
following criteria:
(i) the firm must declare at least two consecutive quarterly regular cash dividends (CRSP
distribution code 1232) and the declaration dates must be in CRSP,
(ii) no other distributions were announced between the declaration of the previous
dividend and the declaration of the current (e.g., Nissim and Zvi (2001)),
(iii) the firm must have earnings announcement dates prior to the dividend announcement
and quarterly earnings information for the twenty-four consecutive quarters prior to
and the eight consecutive quarters following the dividend announcement in
COMPUSTAT,
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(iv) the dividend announcement does not represent a dividend omission or initiation since
omissions and initiations are associated with pronounced market reactions (e.g.,
Asquith and Mullins (1983) and Michaely, Thaler and Womack (1995)),
(v) the firm must maintain dividends or change dividends by at least 10% in absolute
value to ensure that the dividend change is informative (e.g., Yoon and Starks
(1995)),
(vi) past earnings must change by at least 0.5% in absolute value to ensure that the
earnings change is informative (this removes about 7% of our observations), and
(vii)
the dividend announcement must occur at least 2 days after the earningsannouncement. 6
Furthermore, a dividend changer must not reverse that policy in the following four
quarters (our qualitative results remain the same if we require that the policy is not changed in
the following eight quarters). To reduce contamination of the future earnings of the firms that
leave their dividends unchanged, dividend changers are never included in the non-dividend-
changing sample in the following four quarters even if they do not change their dividends in
these quarters. After applying these filters, we are left with a sample of 2,988 instances of
dividend increases, 23,229 cases with unchanged dividends, and 513 cases of dividend
reductions across 2,625 firms.
6 Our qualitative results remain the same if we include dividends that were announced a day after the earningsannouncement or if all dividend changes are included in the sample.
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C. Descriptive Statistics
Each quarter, we sort the firms by the signs of their prior earnings changes and their
dividend changes. Panel A of Table 1 reports the distribution of prior earnings increases of the
firms by their dividend announcements. For these firms, the mean (median) past earnings
increases are 5.38 (3.57), 5.83 (3.49), and 4.99 (3.33) for the firms that increase, maintain, and
reduce their dividends, respectively. Thus, there is no monotonic pattern in earnings increases
across firms that increase, maintain, or reduce dividends. Turning to firms that experience
declines in their prior earnings (Panel B), the mean (median) prior earnings growths are -4.48
(-2.39), -6.57 (-3.87), and -7.54 (-5.35) for the firms that increase, maintain, and reduce their dividends. These results suggest that the increases in past earnings increase monotonically
across firms that increase, maintain, and reduce their subsequent dividends.
Panels C (D) of Table 1 presents the distributions of dividend increases (reductions) by
the sign of prior earnings changes. In Panel C, the mean (median) dividend increases are 0.25
(0.17) and 0.38 (0.17) for the firms that experience past earnings increases and declines,
respectively. Thus, the average dividend increase is not higher among the firms that experience
past earnings increases compared to those that experience past earnings declines. In Panel D,
the mean (median) dividend reductions are 0.39 (0.40) and 0.44 (0.47) for the firms with
increases and those with declines in past earnings, respectively. Thus, it appears dividend
reductions are larger among firms that experience prior earnings declines than those that
experience prior earnings increases.
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D. Prior earnings changes, dividend changes, and future earnings performance
Table 2 presents the mean and median earnings changes for our sample firms sorted by
their past earning changes and dividend announcements. Panel A reports the results for the
firms with prior earnings increases and, therefore, the tests for hypotheses (H1) through (H3).
The results show that the average change in future earnings is higher for the firms with
corroboratory dividend increases than those that leave their dividends unchanged. For instance,
the median earnings changes for the firms with corroborating dividend increases are 0.37 and
1.60 in the four and eight quarters after the dividend increases. Each of these median increases
is significantly higher than the corresponding changes of -0.01 and 0.56 for the firms that donot change their dividends (the p-values of the differences are each less than 0.01). The results
from the means are qualitatively the same. This replicates the Benartzi et al. (1997) result that
higher earnings are more permanent for firms that increase their subsequent dividends than
those that leave their dividends unchanged, supporting (H1).
Turning to the firms that reduce their dividends after earnings increases, we see that their
median earnings changes are 0.44 and 1.59 in the four and eight quarters after the dividend
reductions. Like the firms with confirmatory dividend increases, these median changes are
significantly higher than corresponding changes for the firms that maintain their dividends. The
results from the means deliver the same conclusion. This contradicts (H2) that higher earnings
should reverse more for firms that subsequently reduce dividends than for the firms that
maintain their dividends. Further, contrary to (H3), the change in earnings for firms with
corroboratory dividend increases is not significantly higher than that for firms with
contradictory dividend reductions. These results suggest that the future earnings performance
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of the firms with contradictory dividends reductions is stronger than the permanence
hypothesis suggests. We discuss this result in the next section.
Panel B of Table 2 presents the results for the firms that experience declines in prior
earnings, testing hypotheses (H4) through (H6). The median changes in earnings for the firms
with contradictory dividend increases are 1.95 and 2.49 in the four and eight quarters after the
dividend increases, respectively. These increases are significantly higher than the
corresponding values of 1.18 and 1.91 for firms that do not change their dividends (p-values
for the difference test are less than .01). The results from analyzing the means are similar.
Consistent with the permanence hypothesis, this result suggests that declines in prior earningsreverse more for the firms that increase their dividends than those that maintain theirs,
supporting (H4).
For the firms with confirmatory dividend reductions, the median earnings changes are
0.24 and 1.66 in the first four and eight quarters after the dividend reductions. The change over
the first four quarters is significantly lower than the change for the firms that maintain their
dividends (p-value of the difference is less than .01). Analysis of the means provides same
conclusion. This is consistent with hypothesis (H5) that lower earnings are more persistent
among firms that subsequently reduce their dividends than their counterparts that do not
change their dividends. Finally, our results show that the median increases in the future
earnings of the firms with contradictory dividend increases are higher than those with
confirmatory dividend decreases. Thus, declining earnings reverse more for the firms that
increase subsequent dividends than those that reduce theirs, supporting hypothesis (H6).
In summary, our tests do not reject hypothesis (H1) that higher earnings are more
permanent for firms that increase their subsequent dividends than the firms that maintain their
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dividends. As well, we do not reject hypotheses (H4) through (H6), suggesting that declines in
earnings display greater persistence for firms that subsequently reduce dividends, and they
reverse more for firms that subsequently increase dividends compared to those that leave their
dividends unchanged. This is new evidence in support of the permanence hypothesis. In
contrast, our tests reject hypotheses (H2) and (H3), suggesting higher earnings do not reverse
more for the firms that subsequently reduce dividends than those that maintain or increase their
dividends. In the next section, we discuss the implications of these results.
III.
Discussions of Results
Our evidence from corroboratory dividend changes supports the permanence hypothesis.
While the evidence from confirmatory dividend increases is not new (Benartzi et al. (1997)),
that from confirmatory dividend reductions is new. That is, reduced earnings persist more for
the firms that subsequently reduce their dividends than for those that leave their dividends
unchanged. This result is inconsistent with the documented rebounds in earnings after dividend
reductions (e.g., Benartzi et al. (1997) and Jensen et al. (2010)). However, it is in line with
DeAngelo et al. (1992), who report that losses tend to persist more for firms that reduce their
dividends than those that maintain theirs and is also consistent with market reactions to
confirmatory dividend reductions reported in Koch and Sun (2004). This result suggests that
managers reduce dividends when they expect persistence in reduced earnings.
With regards to firms with contradictory dividend changes, we find reduced earnings tend
to reverse more among firms that subsequently increase their dividends than those that leave
their dividends unchanged. Again, this evidence supports the permanence hypothesis and it
suggests that managers do increase dividends in anticipation of future earnings increases. This
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is consistent with a direct relation between dividend increases and future earnings predicted by
the models of Bhattacharya (1979) and Miller and Rock (1985). These models suggest that, in
the presence of information asymmetry, management can use dividend increases to convey
information about future earnings. Our result shows that managers use dividend increases to
signal future earnings growth if current earnings declines convey poor earnings information,
which contradicts their belief that earnings will grow. Also, the result sheds light on the mixed
evidence on the relation between dividend increases and future earnings growth. For instance,
while Aharony and Dotan (1994) and Nissim and Ziv (2001) document a positive relation
between increases in dividends and future earnings changes, Bernatzi et al. (1997) and Grullonet al. (2005) suggest that there is no relation. Our result suggests that the positive relation
between dividend increases and future earnings is peculiar to firms with declines in their prior
earnings.
The result from contradictory dividend reductions, however, does not support the
permanence hypothesis. Specifically, following earnings increases, the future earnings changes
of the firms that reduce their dividends are not lower than those that maintain or increase their
dividends. Thus, it does not appear that contradictory dividend reductions signal reversal of
prior earnings increases or declines in future earnings. 7 We provide an explanation that hinges
on managers reluctance to provide bad news (reduce dividends) due to the associated negative
market reactions. In particular, since management is not enthusiastic about reducing dividends
it will try not to reduce the dividend even if it anticipates that the current earnings increases
will reverse. It will rather wait until it is compel by actually deteriorations in earnings to reduce
dividends. Thus, dividend reductions that follow earnings increases may be motivated by
7 Several studies document growth in earnings after dividend reductions (e.g., Benartzi et al. (1997) and Jensen etal. (2010)).
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concerns that the increases in current earnings will reverse. Thus, unlike contradictory dividend
increases where eagerness to provide goods news can result in dividend increases in
anticipation of reversals in current earnings declines, it is hard to see why bad news adverse
managers will reduce dividends in anticipation of reversals in current earnings increases. We,
therefore, investigate the policy of reduced dividends after an increase in earnings.
The strong earnings performance of the firms with contradictory dividend reductions
points to growth-motivated dividend reductions. The future earnings growth can be due to
increased investments or to cost savings from letting future growth options expire (Jensen et al.
(2010)), in which case investment will fall. To investigate this, we calculate the median capitalexpenditure and median change in capital expenditure of our sample firms and report the
results in Table 6. From the table, the median investment per book value of assets in the four
and eight quarters after the dividend announcement is highest for the firms with contradictory
dividend reductions. Also, these firms display the highest increases in capital expenditure in
the same periods. 8 This suggests that contradictory dividend reductions are motivated, at least
in part, by cash needs to fund investment. Thus, with the exception of contradictory dividend
reductions, our evidence shows that dividend changes are managerial signals about the
permanence of prior earnings changes.
8 These results are contrary to those from several prior studies that report declines in capital spending after dividend reductions (e.g., Yoon and Starks (1995) and Jensen et al. (2010)). Our finding, however, is consistentwith Grullon et al. (2002), who report increases in capital expenditure after dividend reductions. Our results showthat firms with confirmatory dividend reductions reduce their capital expenditures while those with contradictorydividend reductions increase them.
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IV. Robustness
Previous studies show that alternate models of earnings dynamics can deliver
fundamentally different results (e.g., alternative assumptions about mean revision in earnings
resulted in Nissim and Ziv (2001) and Grullon et al. (2005) reaching different conclusions
regarding the relation between dividend changes and future earnings changes). To minimize
the possibility that our results are driven by earnings dynamics, we check our results by using a
matched samples as well as different measures for changes in earnings.
A. Matching firms
Our previous results compare the dividend changers to all their non-dividend-changing
counterparts. In this section, we use past earnings performance and industrial matches to check
our results. To match on past performance, we follow Benartzi et al. (1997) and use as controls
the non-dividend-changing firms whose prior earnings changes are within two percent of the
respective dividend changers mean (median) in the mean (median) analysis. 9 Relative to the
results reported in Table 3, the mean (median) prior earnings changes for the dividend changers
and their matched groups are closer and the significant differences disappear. Despite this, our
conclusions are unchanged, suggesting they are not driven by differences in past earnings
performance.
To match by industry, we adjust each firms earnings change by the average change for
the firms in the industry that do not change their dividends. Thus, firm is earnings change is
computed as:
)/)(1
/)((*100 0,1
7,4,3,0,0,7,4,3,0,0, j
J
j j jiiii BE E E J
BE E E Y
9 We do not match dividend reducers against dividend increasers due to the limited number of observations.
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where j = 1,...,J are all the firms that do not change their dividend in the quarter and are in the
same industry as firm i, defined by the two-digit Standard Industrial Classification (SIC) code.
We adjust earnings changes for the industry means before classifying them by the sign of their
past earnings changes and, hence, the means for the non-dividend-changing groups are not
equal to zero. The results, presented in Table 4, are qualitatively the same as those reported
earlier, indicating that our results are not influenced by differences in industrial composition of
our test groups.
B.
Other measures of earnings changeThe other metrics that we use to capture changes in earnings are:
(i) the seasonal random walk earnings change scaled by the book value of common equity,
calculated as 0,4,0,0, /)(*100 iiii BE E E Y ,where E i,t is the earnings of firm i in quarter t (e.g.,
Koch and Sun (2004)). Y i,4 and Y i,8 are the sum of the quarterly earnings changes in the four
and eight quarters after the dividend announcements.
(ii) the change in earnings in the first four quarters over the preceding four quarters scaled by
the book value of common equity, computed as ./)(*100 0,7,4,3,0,0, iiii BE E E Y
(iii) the earnings change adjusted for linear mean revisions in earnings, computed as:
),(*100 04, iY where 0 and are the estimates of 0 and from the following pooled
regression:
( E i,4,1 E i,0,-3 )/ BE i,0 = 0 + 2 ROE i,0 + 3(E i,0,-3 E i,-4,-7 )/BE i,0 + i,4,0 , (1)
and ROE i,0 = E i,0,-3 /BE i,0. We compute Y i,8 in the same fashion by replacing E i,4,1 in equation
(1) with E i,8,5. ROE and prior earnings performance capture mean reversion in future earnings
and we obtain negative coefficient estimate on each (e.g., Nissim and Ziv (2001)). Adding
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dummies for positive and negative dividend changes as additional regressors does not affect
our conclusions.
(iv) change in earnings adjusted for nonlinear mean revisions, computed as
),(*100 04, iY and 0 and are the estimates of 0 and from the following pooled
regression:
( E i,4,1 E i,0,-3 )/ BE i,0 = + 1 RE i,0 + 2 ND0*RE i,0 + 3 ND0*(RE i,0 )2 + 4 PD 0*(RE i,0 )2 + 1CE i,0 +
2 AD0*CE i,0 + 3 AD0*(CE i,0 )2 + 4 BD0*(CE i,0 )2 + i,4,0 (2)
RE 0 = ROE 0 E[ ROE 0], where E[ ROE 0] is the fitted value from the cross-sectional regression
of ROE 0 on its lagged value, and on the logarithm of total assets and of the market-to-book
ratio of equity in the preceding quarter; CE 0 = ( E 0,-3 E -4,-7 )/ B-1; ND ( PD ) is a dummy variable
set to one if RE 0 is negative (positive) and zero otherwise, and AD ( BD) is a dummy variable
set to one if CE 0 is negative (positive) and zero otherwise. Again, Y i,8 is obtained by replacing
E i,4,1 in equation (2) with E i,8,5. The dummy variables and the squared terms account for the
findings that large changes in earnings revert faster than small changes and negative changes
revert faster than positive changes (e.g., Grullon et al. (2005)).
To conserve space, we only report the results from the medians in these alternate tests in
Panels A through D in Table 5 (the mean results are similar). It is evident that our conclusions
remain the same in each of these alternative specifications of earnings changes. Thus, it does
not appear that our results are influenced by different evolution processes in earnings across
our test groups.
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C. Alternative Deflators for Earnings Change and Dividend Change
We repeat our tests using alternative deflators for earnings changes. These include market
value of common equity, market value of the firm, and book value of the firm. In addition, we
repeat the analysis deflating the dividend change by the book value of common equity and by
the closing price on the dividend-announcement day and excluding firms whose dividend
change is in the decile closest to zero. In all cases, the results are qualitatively the same as
those tabulated.
V. Concluding Comments
It is well-documented that dividend changes induce stock price changes, but there is no
consensus on the exact information that the markets react to. Cash flow models suggest that
dividend changes are a signal about future earnings growth. Collectively, the evidence from
future earnings patterns does not support this view. More recent empirical work by Koch and
Sun (2004) finds that market reactions to dividend changes suggest that investors interpret
dividend changes as revealing private managerial information about the permanence of prior
earnings changes. This view, too, has implications for future earnings behavior. In particular, it
suggests that increased earnings should be more permanent (transitory) for firms that
subsequently increase (reduce) their dividends than those that maintain their dividends.
Likewise, reduced earnings should be more permanent (transitory) for the firms that
subsequently reduce (increase) their dividends than those that maintain their dividends.
Consequently, we study the hypothesis that dividend changes are signals about the permanence
of past earnings changes based on the future earnings patterns of firms sorted by their past
earnings performance and their dividend announcements.
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Since the contrary evidence from contradictory dividend reductions stems from stronger
future earnings growth, we investigate the capital expenditures of our sample firms and find
that contradictory dividend reducers display the largest increases in capital expenditure. This
suggests that the policy to reduce dividends following earnings increases are likely driven by
cash needs to boost investment activities. Overall, therefore, the evidence from future earnings
patterns supports the view that dividend changes reflect private managerial information about
the persistence of prior earnings changes.
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Table 1Distribution of Changes in Earnings and Dividends
The table presents the distribution of prior earnings changes by dividend announcements for firms withquarterly regular cash dividend information in CRSP and quarterly earnings, along with their announcement dates in COMPUSTAT. The sample covers January 1979 through December 2009. Toremain in the sample the firm must have twenty-four consedecreaseive quarters of earnings before andeight consedecreaseive quarters of earnings after the dividend announcements. Each quarter, the firmsare sorted by the changes in earnings, computed as 0,7,4,3,0,0, /)(*100 iiii BE E E E , where E i,t,x is the sum of firm is earnings from quarter t to quarter x and BE i,t is the book value of the firmscommon equity at the end of quarter t . The firms are then classified by their subsequent dividendannouncements.
Percentiles P1 P10 P25 P50 P75 P90 P99 Mean Firm-quarters
Panel A: Distribution of Prior Earnings Increases by Dividend Announcements
Dividend Increases 0.37 1.47 2.26 3.57 6.02 10.62 29.77 5.38 2,374
Unchanged Dividends 0.16 0.88 1.75 3.49 6.86 13.24 34.55 5.83 11,882
Dividend Decreases 0.17 1.20 2.13 3.33 5.86 9.79 23.56 4.99 232
Panel B: Distribution of Prior Earnings Declines by Dividend Announcements
Dividend Increases -0.07 -0.34 -0.87 -2.39 -5.49 -10.59 -28.30 -4.48 614
Unchanged Dividends -0.13 -0.66 -1.62 -3.87 -8.41 -14.98 -39.38 -6.57 11,347
Dividend Decreases -0.10 -0.62 -1.66 -5.35 -10.94 -15.76 -42.98 -7.54 281
Panel C: Distribution of Dividend Increases by Prior Earnings Changes
Earnings Increases 0.10 0.11 0.12 0.17 0.25 0.40 1.40 0.25
Earnings Declines 0.10 0.11 0.12 0.17 0.25 0.50 2.00 0.38
Panel D: Distribution of Dividend Decreases by Prior Earnings Changes
Earnings Increases -0.12 -0.20 -0.30 -0.40 -0.50 -0.50 -0.71 -0.39
Earnings Declines -0.13 -0.20 -0.32 -0.47 -0.5 -0.71 -0.90 -0.44
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Table 2Future Earnings Changes by Current Earnings Changes and Dividend Announcements
The table presents the future earnings changes for firms classified by their prior earnings changes andtheir dividend announcements for firms with quarterly regular cash dividend information in CRSP andquarterly earnings information in COMPUSTAT. The sample covers January 1979 through December 2009. Each quarter, the firms are sorted by the changes in their earnings, computed as,
/)4/)()((*100 0,23,20,7,4,7,4,3,0,1, iiiiii BE E E E E E where E i,t,x is the sum of firm isearnings from quarter t to quarter x and BE i,t is the book value of the firms common equity at the end of quarter t . The firms are then classified by their subsequent dividend announcements. Panel A presentsthe results for prior earnings increases and Panel B for prior earnings declines.
Dividend Increases Unchanged Dividends Dividend Reductions
Panel A: Earnings Increases
Previous Four Quarters 4.57**
[2.47] ** 6.51
[3.48]4.66 **
[2.83] **
First Four Quarters -0.32**
[0.37] ** -0.94
[-0.01]-0.43 ** [0.44] **
First Eight Quarters -0.18**
[1.60] ** -0.52[0.56]
0.04 ** [1.59] **
Panel B: Earnings Decreases
Previous Four Quarters -6.58**(##)
[-4.25] **(##) -7.71
[-4.76]-8.30 **
[-5.98] **
First Four Quarters 2.93**(##)
[1.95] **(##) 2.14
[1.18]0.63 **
[0.24] **
First Eight Quarters 2.34[2.49] **(##) 2.39
[1.91]2.45
[1.66]*,** Significantly different from the no-change group at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.#,## Significantly different from the dividend reducers at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.
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Table 3
Matching Dividend Maintainers to Changers by Past PerformanceThe table presents the future earnings changes measured differently for firms by their prior earningschanges and their dividend announcements. The sample covers January 1979 through December 2009.To be included in the sample, the firm must have quarterly regular cash dividend information in CRSPand quarterly earnings information in COMPUSTAT. Each quarter, the firms are sorted by the changesin their earnings, computed as ,/)4/)()((*100 0,23,20,7,4,7,4,3,0,1, iiiiii BE E E E E E where E i,t,x is the sum of firm is earnings from quarter t to quarter x and BE i,t is the book value of thefirms common equity at the end of quarter t . The firms are then classified by their subsequent dividendannouncements. The dividend changers are matched against their counterparts that left their dividendsunchanged and their year 0 earnings changes within two percentage points of the mean (median) inmean (median) analysis for the respectively change group. Panel A presents the results for prior earnings increases and Panel B for prior earnings declines.
Dividend Increases Dividend Reductions
IncreasesMatched
Non-Change ReductionsMatched
Non-Change
Panel A: Prior Earnings Increases
Previous Four Quarters
4.57[2.47]
4.31[2.52]
4.66[2.83]
4.45[2.71]
First Four Quarters -0.32**
[0.37] ** -1.08
[-0.16]-0.43 ** [0.44] **
-0.96[-0.22]
First Eight Quarters -0.18**
[1.60] ** -0.64[0.41]
0.04[1.59] **
-0.20[0.39]
Panel B: Prior Earnings Decreases
Previous Four Quarters
-6.58[-4.25]
-6.36[-3.98]
-8.30[-5.98]
-8.11[-5.77]
First Four Quarters 2.93**
[1.95] ** 0.47
[0.49]0.63 **
[0.24] ** 1.53
[0.96]
First Eight Quarters 2.34**
[2.49] ** 0.72
[1.12]2.45
[1.66]2.74
[1.41]*,** Significantly different from the matched no-change group at the 10% and 1% levels using a two-
tailed Students t -test for the means and a two-tailed Wilcoxon test for the medians.#,## Significantly different from the dividend reducers at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.
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Table 4
Earnings Changes Adjusted by IndustryThe table presents the future earnings changes for firms classified by their prior earnings changes
and their dividend announcements for firms with quarterly regular cash dividend information in CRSPand quarterly earnings information in COMPUSTAT. The sample covers January 1979 throughDecember 2009. Each quarter, we calculate earnings change for each firm i as
,)/)(1
/)((*100 0,1
7,4,3,0,0,7,4,3,0,0, j
J
j j jiiii BE E E J
BE E E E
where j = 1, ... , J are all the firms that did not change their dividend in the quarter and have thesame two-digit Standard Industrial Classification (SIC) code as firm i. The firms are thenclassified by their earnings change and their subsequent dividend announcement. Panel A presents theresults for prior earnings increases and Panel B for prior earnings declines. Medians are reported insquare brackets.
Dividend Increases Unchanged Dividends Dividend Reductions
Panel A: Earnings Increases
Previous Four Quarters 5.15**
[3.40] ** 4.69
[3.04]4.82
[3.48] **
First Four Quarters 0.91**(##)
[0.76] **(#) -0.89
[-0.38]-0.10 ** [0.37] **
First Eight Quarters 0.83**
[1.06] ** -0.99
[-0.45]0.49 **
[1.02] **
Panel B: Earnings Decreases
Previous Four Quarters -4.12 **(##) [-2.51] **(##) -4.88
[-3.06]-6.26 ** [-3.29]
First Four Quarters 2.14**(##)
[1.25] **(##) 0.93
[0.66]0.16 **
[-0.25] **
First Eight Quarters 2.24**(##)
[1.58] **(##) 1.03
[0.96]-0.03 ** [0.02] **
*,** Significantly different from the no-change group at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.#,## Significantly different from the dividend reducers at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.
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Table 5Different Measures of Earnings Changes
The table presents the median percentage future earnings changes, computed with different metrics, for firms by their prior earnings changes and their dividend announcements. The sample covers January1979 through December 2009. To be included in the sample, the firm must have quarterly regular cashdividend information in CRSP and quarterly earnings information in COMPUSTAT. Each quarter, thefirms are sorted by the changes in their past earnings changes and by their subsequent dividendannouncements. E i,t, is the earnings of firm i in quarter t ; E i,t,x is the sum of firm is earnings fromquarter t to quarter x, and BE i,t is the book value of common equity at the end of quarter t .
Prior Earnings Increases Prior Earnings Declines
DividendIncreases
UnchangedDividends
DividendReductions
DividendIncreases
UnchangedDividends
DividendReductions
Panel A: Seasonal Random Walk Changes computed as 0,4,0,0, /)(*100 iiii BE E E E
SubsequentFour Quarters 2.48
** 1.36 2.29 ** 0.78 **(##) -0.94 -2.68 **
SubsequentEight Quarters 2.93
** 1.65 3.16 ** 0.04 **(##) -0.49 -2.09 **
Panel B: Four-Quarter Changes computed as: 0,7,4,3,0,0, /)(*100 iiii BE E E E
SubsequentFour Quarters 1.84
**(##) -0.23 1.13 ** 3.17 **(##) 0.89 -1.99 **
SubsequentEight Quarters 1.80
** 0.00 1.71 ** 3.04 **(##) 1.30 0.51 **
Panel C: Earnings Changes Adjusted for Linear Mean Revisions computed using Equation (1)
SubsequentFour Quarters 2.90
** 1.71 2.78 ** 0.43 **(##) -1.76 -4.16 **
SubsequentEight Quarters 2.75
** 1.35 2.69 ** -1.58 **(##) -3.20 -4.45 **
Panel D: Earnings Changes Adjusted for Nonlinear Mean Revisions computed using Equation (2)
SubsequentFour Quarters 1.42
** 0.43 1.34 ** 1.78 **(##) -0.12 -1.56 **
SubsequentEight Quarters 1.33
** -0.11 1.25 ** 0.05 **(##) -1.81 -3.45 **
*,** Significantly different from the no-change group at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.#,## Significantly different from the dividend reducers at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.
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Table 6
Capital Expenditures by Past Performance and Dividend ChangesThe table presents the median capital expenditures for our sample of the firms by their prior earnings
performance and their dividend announcements. The sample period covers January 1979 throughDecember 2009. Each quarter, the firms are sorted by the changes in their earnings, computed as
,/)4/)()((*100 0,23,20,7,4,7,4,3,0,1, iiiiii BE E E E E E where E i,t,x is the sum of firm isearnings from quarter t to quarter x and BE i,t is the book value of the firms common equity at the end of quarter t . The firms are then classified by their subsequent dividend announcements. Capitalexpenditure is the expenditure in subsequent four and eight quarters after the dividend announcements,scaled by the book value of the firms assets.
Capital Expenditure Levels Percentage Changes in Capital Expenditure
DividendIncreases
UnchangedDividends
DividendReductions
DividendIncreases
UnchangedDividends
DividendReductions
Panel A: Prior Earnings Increases
Most RecentFour
Quarters0.045 (#) 0.043 0.050 ** 2.1 ** -0.8 3.6 *
SubsequentFour
Quarters0.046 (##) 0.044 0.056 ** 2.9 (#) 1.5 5.9 *
SubsequentEight
Quarters0.098 0.092 0.107 * 107.1 105.6 107.8
Panel B: Prior Earnings Declines
Most RecentFour
Quarters0.047 (##) 0.049 0.035 ** -4.9 * -7.2 -6.5
SubsequentFour
Quarters0.045 *(##) 0.040 0.026 ** -1.9 **(##) -10.5 -12.3
SubsequentEight
Quarters0.094 *(##) 0.086 0.061 ** 105.9 **(##) 80.6 69.6 *
*,** Significantly different from the no-change group at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.#,## Significantly different from the dividend reducers at the 10% and 1% levels using a two-tailedStudents t -test for the means and a two-tailed Wilcoxon test for the medians.