Why do firms pay dividends? A well-known finance theory proposes that, in frictionless markets, dividends are irrelevant for firm valuation because an investor’s wealth does not change if the firm holds a dollar in the bank or if the firm returns a dollar to an investor through a dividend who then holds it in the bank.[1] Despite this, roughly 40 percent of public firms pay dividends and, because they are rarely cut, dividends provide investors with a predictable stream of cash. Research has had limited success in explaining why firms pay dividends (i.e. the benefits), but the costs, such as increased taxes, have been well documented.
In our recent paper, “Attention to dividends, inattention to earnings?”,[2] we argue that paying dividends benefits firms by supplying information about the firms’ level of permanent earnings. Although earnings may fluctuate from quarter-to-quarter, the cash generated on average should be at least sufficient to fund the dividend. We expect the information about permanent earnings decreases investors’ demand for, and the information contained in, other sources of earnings information such as earnings announcements. This potentially benefits firms by reducing investors’, and in turn managers’, fixation on earnings. The fixation on earnings is costly because it leads firms to expend resources managing earnings expectations, managing reported earnings to reach those expectations, and ultimately helping investors interpret earnings after the earnings announcement. As a result, because dividends are infrequently cut, they supply information about permanent earnings and thus serve as a substitute source of information about earnings and the profitability of the firm, thereby affecting investor, market, and firm behaviors at the earnings announcement.
Our initial analysis provides evidence that dividends decrease the information disseminated to investors at earnings announcements. Comparing the valuation implications of earnings surprises – the amount by which reported earnings differ from expectations – for dividend payers versus non-payers, we find that dividend payers have 11 percent to 15 percent lower responses to earnings news, measured as the difference between reported earnings and the analyst consensus forecast scaled by price. This is consistent with our hypothesis that the availability of a signal about permanent earnings (i.e. the dividend) substitutes for the information about profitability that otherwise would be impounded in share price at the earnings announcement. We also find the price responds less to earnings news when the firm announces the dividend shortly before the earnings announcement, consistent with timelier dividend information leading to greater substitution. The converse is also true: Price reactions to dividend changes decrease with the proximity of the earnings announcement, again consistent with earnings and dividends serving as substitute information sources.
We show the weaker valuation implications translate into lower investor attention to earnings announcements for dividend payers. We find 3 percent to 8 percent less trading volume, lower return volatility, and fewer analyst-forecast revisions at the earnings announcement for dividend payers relative to non-payers. In additional analysis, we find no differences between payers’ and non-payers’ post-earnings announcement returns, consistent with the differences in market reactions arising because the dividend is a substitute source of earnings information, so for payers the earnings announcement supplies less incremental information about future earnings.
Finally, we examine several firm behaviors to provide evidence that the reduction in investor attention affects managerial behaviors. Because market participants focus less on the earnings of dividend payers, we predict managers will also focus less on earnings, leading to less earnings manipulation. We focus on managers’ attempts to meet or beat analysts’ earnings forecasts because managers spend resources on those attempts and jeopardize their careers when they miss the targets. Consistent with our expectations, we show dividend payers just meet or beat (miss) analysts’ earnings estimates less (more) frequently than non-payers, suggesting that dividends allow payers to focus less on costly earnings manipulation. Notably, we find that managers of payers are less likely to reduce research and development spending to meet earnings targets. We also find that those managers are more likely to discuss earnings on conference calls when just meeting or beating expectations, but less likely to do so than managers of payers are. That payers emphasize earnings less during conference calls supports our view that managers of payers focus less on reported earnings. Similarly, we find that managers are less likely to expend effort developing and reporting non-GAAP earnings measures or releasing earnings forecasts when their firms pay dividends, suggesting that the information in the dividend reduces the need to provide information via other sources. Managers focusing less on window-dressing their financial reporting plausibly frees them to focus on other projects, which potentially will contribute more long-term value to shareholders.
In sum, we find that dividends provide information that substitutes for the information in earnings. This benefits firms by reducing their efforts to manipulate earnings and to provide earnings-related disclosure. This new evidence on the benefits of dividend paying potentially helps explain the “puzzle” of dividend paying given dividend irrelevance and may be of interest to both regulators and commentators concerned that firms focus too heavily on short-term earnings targets.
ENDNOTES
[1] Miller, M.H., and F. Modigliani. 1961. Dividend policy, growth, and the valuation of shares. The Journal of Business 34 (4): 411-433.
[2] Ham, C., Z. Kaplan, and S. Utke. 2021. Attention to dividends, inattention to earnings? Review of Accounting Studies, forthcoming.
This post comes to us from professors Charles Ham and Zachary Kaplan at Washington University in St. Louis’ John M. Olin Business School and Steven Utke at the University of Connecticut. It is based on their recent article, “Attention to Dividends, Inattention to Earnings?” available here.