The Dividend Puzzle: The Relationship Between Payout Rates and Growth
by Stanley Block
In one of the most surprising research developments over the last four decades, Robert Arnott and Clifford Asness published an article in the January/February 2003 issue of the Financial Analysts Journal entitled “Surprise! Higher Dividends = Higher Earnings Growth.”
The article carries more than normal credibility in that Mr. Arnott is a prior editor of the prestigious journal, and Mr. Asness is on the editorial board. In the 2003 publication the authors stated, “The historical evidence strongly suggests that expected earnings growth is fastest when current payout ratios (of dividends) are high and slowest when payout ratios are low.”
In this article
- Dividend Policy and Stock Price
- A Longer-Term Perspective
- Where Did the Money Go?
- Dividends in the Current Market
- DRIPs and Dividends
- Summary and Conclusion
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This would appear to be a form of academic betrayal, as virtually every textbook and article on dividends suggests that low dividend-paying stocks provide the greatest growth potential. The typical academic literature is even backed up by the “sustainable growth model” measure of valuing stock prices, which suggests that future growth is largely supported by the percentage of retained earnings that is reinvested in the corporation (and not paid out as dividends).
The academic rebels, however, back up their high dividend, high earnings evidence with the argument that companies that pay high dividends are generally confident in their ability to provide strong earnings growth in the future. Were this not the case, the authors suggest, the firms would hoard each dollar of current earnings in a “so-called” contingency fund to protect against future developments.
Another explanation by the authors is that high earnings retention and a low dividend payout may signal an attempt at empire-building by current management. In order to develop a larger enterprise and the higher executive compensation that often goes with that, management may engage in developmental projects that do not represent the best interest of stockholders. While this is not always the case, it happens often enough to capture investors’ attention. One need only look at the evidence on corporate divestitures and spin-offs of unwanted divisions to realize that many prior empire-building mistakes by management have to be corrected at a later date.
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