The Effect of Dividend Changes on Expected Cash Flows

A University of Chicago working paper challenged the viewpoint that positive revisions are often viewed as conveying optimism on the part of management about future earnings and cash flows, while negative revisions are perceived as conveying pessimism.

Dividend announcements and changes are perceived as signaling information about a company’s financial prospects. Positive revisions are often viewed as conveying optimism on the part of management about future earnings and cash flows, while negative revisions are perceived as conveying pessimism. A University of Chicago working paper challenges this viewpoint. The study’s authors find evidence of a link between dividend announcements and future changes in cash flow volatility.

Dividend increases are followed, in aggregate, by a reduced variance in cash flows (referred to as “cash-flow news”) over the next five years. Put another a way, there is 15% less volatility in future cash flows following an announcement of a higher dividend relative to what there was during the five-year period preceding the announcement.

The opposite occurs with dividend decreases—the variability of expected cash flows increases. Specifically, there is 7% greater volatility in cash-flow news following a cut to the dividend. Omitting the dividend altogether leads to a similar increase in cash-flow news variance.

The different reactions imply that a correlation exists between dividend changes and a subsequent change in the variance of cash-flow news in the opposite direction. The study’s authors interpret their finding as implying that companies “change their dividend payout in anticipation of future changes in cash-flow volatility.”

Larger dividend hikes have a greater impact. The variance in post-increase cash-flow news drops by more than 19% on average for larger-than-median hikes. Smaller-than-median dividend increases tend to be followed by 8% smaller decreases in variance.

There is also a link between the type of dividend change and the announcement return. (The announcement return is the cumulative returns during a three-day window bracketing the dividend announcement event.) Announcement returns are “significantly larger” (meaning more positive) for above-median dividend increases than they are for below-median increases. When dividends are cut, announcement returns are “significantly” more negative for larger-than-median decreases than they are for smaller-than-median decreases.

“The Information Content of Dividends: Safer Profits, Not Higher Profits;” Roni Michaely, Stefano Rossi and Michael Weber; Becker Friedman Institute for Research in Economics; Working Paper Series No. 2017-19; November 2017.