Are Future Earnings Related to Past Earnings Performance and Dividend.pdf

7/28/2019 Are Future Earnings Related to Past Earnings Performance and Dividend.pdf

1/33


2/33Electronic copy available at: http://ssrn.com/abstract=1782122

2

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).


3/33Electronic copy available at: http://ssrn.com/abstract=1782122

3

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.


4/33

4

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


5/33

5

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.


6/33

6

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.


7/33

7

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.


8/33

8

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.


9/33

9

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


(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


(H5): Following earnings declines, Y0,T is on average lower for the firms that reduce


(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.


10/33

10

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.


11/33

11

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,


12/33

12

(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.


13/33

13

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.


14/33

14

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


15/33

15

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


16/33

16

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


17/33

17

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)).


18/33

18

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.


19/33

19

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.


20/33

20

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


21/33

21

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.


22/33

22

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.


23/33


24/33

24

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.


25/33

25

References

Aharony, Joseph, and Amihud Dotan, 1994, Regular dividend announcements and future

unexpected earnings: An empirical analysis, Financial Review 29, 125-151.

Asquith, Paul, and David W. Mullins, 1983, The impact of initiating dividend payments on

shareholders wealth, Journal of Business 56, 77-96.

Benartzi, Shlomo, Roni Michaely, Richard Thaler, 1997, Do changes in dividends signal the

future or the past? Journal of Finance 52, 1007-1034.

Bhattacharya, S., 1979, Imperfect information, dividend policy, and the bird in the hand

fallacy, Bell Journal of Economics 10, 259-270.Brickley, J. A., 1983, Shareholder wealth, information signaling and the specially designated

dividends: An empirical study . Journal of Financial Economics 12, 187-209.

DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, 1992, Dividends and Losses,

Journal of Finance 47, 1837-1863.

DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, 1996, Reversal of fortune:

Dividend signaling and the disappearance of sustained earnings growth, Journal of

Financial Economics 40, 341-371.

Foster, George, 1977, Quarterly accounting data: Time series properties and predictive ability

results, Accounting Review 52, 1-21.

Gonedes, Nicholas J., 1978, Corporate signaling, external accounting, and capital market

equilibrium: Evidence on dividends, income and extraordinary items, Journal of

Accounting Research 16, 26-79.


26/33

26

Grullon, Gustavo, Roni Michaely, Shlomo Benartzi, and Richard H. Thaler, 2005, Dividend

changes do not signal changes in future profitability, Journal of Business 78, 1659-

1682.

Healy, P. M. and K. G. Palepu, 1988, Earnings information conveyed by dividend initiations

and omissions, Journal of Financial Economics 21, 149-175.

Jensen, Gerald R., Leonard Lundstrum, and Robert Miller, 2010, What do dividend reductions

signal? Journal of Corporate Finance 16, 736-747.

John, K. and J. Williams, 1985, Dividends, dilution, and taxes: A signaling equilibrium.

Journal of Finance 40, 1053-1070.Kane A, Y. K. Lee, and A. Marcus, 1984, Earnings and dividend announcements: Is there a

corroboration effect? Journal of Finance 39, 1091-1099.

Koch, A. S. and A. X. Sun, 2004, Dividend changes and the persistence of past earnings

changes, Journal of Finance 59, 2093-2116.

Lintner, John, 1956, The distribution of incomes of corporations among dividends, retained

earnings and taxes, American Economic Review 46, 97-113.

Michaely, Roni, Richard Thaler, and Kent Womack, 1995, Price reactions to dividend

initiations and omissions: Overreaction or drift? Journal of Finance 50, 573-608.

Miller, M. H. and F. Modigliani, 1961, Dividend policy, growth, and the valuation of shares,

Journal of Business 34, 411-433.

Miller, M. H. and K. Rock, 1985, Dividend policy under asymmetric information, Journal of

Finance 40, 1031-1051.

Nissim, Doron and Amir Ziv, 2001, Dividend changes and future profitability, Journal of

Finance 56, 2111-2133.


27/33

27

Penman, S. H., 1983, The predictive content of earnings forecasts and dividends, Journal of

Finance 38, 1181-1199.

Watts, R., 1973, Information Content of Dividends. Journal of Business 46, 191-211.

Yoon, Pyung S., and Laura T. Starks, 1995, Signaling, investment opportunities, and dividend

announcements, Review of Financial Studies 8, 995-1018.


28/33

28

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


29/33

29

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.


30/33

30

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.


31/33

31

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] **


[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]


[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.


32/33

32

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


**(##) -0.23 1.13 ** 3.17 **(##) 0.89 -1.99 **


** 0.00 1.71 ** 3.04 **(##) 1.30 0.51 **

Panel C: Earnings Changes Adjusted for Linear Mean Revisions computed using Equation (1)


** 1.71 2.78 ** 0.43 **(##) -1.76 -4.16 **


** 1.35 2.69 ** -1.58 **(##) -3.20 -4.45 **

Panel D: Earnings Changes Adjusted for Nonlinear Mean Revisions computed using Equation (2)


** 0.43 1.34 ** 1.78 **(##) -0.12 -1.56 **


** -0.11 1.25 ** 0.05 **(##) -1.81 -3.45 **



33/33

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 *


Are Future Earnings Related to Past Earnings Performance and Dividend.pdf

Documents

Transcript of Are Future Earnings Related to Past Earnings Performance and Dividend.pdf