The Surprising Link Between Dividends & Earnings

The Surprising Link Between Dividends & Earnings

The Surprising Link Between Dividends & Earnings by Sure Dividend

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How can you really trust that a company’s public statements are accurate?

The 2002 Sarbanes-Oxley Act was supposed to make accounting statements more transparent in the wake of the Enron scandal.

There are many who feel that Sarbanes-Oxley has only made financial statements more confusing.

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How are we supposed to know whether or not the profits reported on accounting statements are real, tangible earnings, or an accounting fiction?

It is virtually impossible for the individual investor to go and visit the corporate headquarters of all of their stock holdings and have a chat with the CEO of major corporations.  Even if you could, a dishonest CEO wouldn’t openly come forward with any discrepancies.

Is there a way to confirm the earnings on the income statement and the cash flows on the cash flow statement?

Dividends Are the Answer

The answer is that dividend paying companies must be making money, or they wouldn’t be able to pay out dividends for very long.

If a company can pay out dividends, it must be generating positive cash flows.  If it isn’t, it will soon be forced to cut its dividend payments.

Dividends show earnings are real.  Dividend growth shows real earnings growth.  That’s why Dividend Aristocrats tend to do so well over time.

Dividends Increases Confirm Earnings Growth

The only way a management team can consistently raise its dividend payments is if earnings are truly rising year-after-year.

If growth is not persistent, then management would not be able to continue raising dividends.

A 2004 study by Koch and Sun examines whether the market interprets changes in dividends as a signal about the persistence of past earnings growth.  Here’s what they found:

“Results confirm the hypothesis that changes in dividends cause investors to revise their expectations about the persistence of past earnings changes.  The effect varies predictably with the magnitude of the dividend change and the sign of the past earnings change.”

When a company raises its dividends, the market decodes this signal as proof that the business has actually grown (or shrunk if dividends were reduced).

Dividends & Earnings Quality

Businesses that pay consistently increasing dividends are telling us something about the qulity of their earnings.

Consistent dividend increasers show confidence that their business is growing and will continue to grow.  It’s more than just projecting confidence – almost every CEO does that…  Why wouldn’t they?

Consistently rising dividends show real confidence that a business has a strong and durable competitive advantage that affords it increasing profits.  This is much more than typical CEO puffery.

A 2009 study by Skinner and Soltes investigated how informative dividend payout policy is with respect to earnings quality changes over time.  They found that:

“The reported earnings of dividend paying firms are more persistent than those of other firms and that this relationship is remarkably stable over time.

We also find that dividend payers are less likely to report losses and those losses that they do report tend to be transitory losses driven by special items.”

Simply put, dividend paying firms have more stable earnings and report fewer losses than non-dividend paying firms.

Dividend are a measure of quality, in addition to shareholder friendliness.

Dividends & Future Earnings Growth

The prevailing logic about payout ratios is as follows:

The higher the payout ratio, the slower the growth rate.  This makes logical sense in a perfect world.  If a company pays out most of its earnings as dividends, it has less money to invest in growth projects.  This should reduce growth.

The real world is far from perfect (news flash, I know).  A competing ideology to the prevailing log about payout ratios is that a high payout ratio signals future earnings growth and confidence from management.

A 2003 paper by Clifford Asness and Robert Arnott found the following:

“We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come.”

Their work has been confirmed in several other research papers.  In the 2007 paper Are Dividend Informative About Future Earnings?,  Hanlon, Myers, and Shevlin found that:

“Overall, our results are consistent with dividends providing relevant information about future earnings to the market that is not in current earnings and that this information is incorporated into stock price.”

The above study shows (again) that dividend growth gives investors new information about expected earnings growth.  The more rapid dividends grow, the quicker earnings are expected to grow (on average).

In the 2006 paper Dividend Payout and Future Earnings Growth Zhou and Ruland found that:

“Our tests also show that high-dividend-payout companies tend to experience strong, not weak, future earnings growth. These results are robust to alternative measures of payout and earnings, sample composition, mean reversion in earnings, the effects of particular industries, time periods, and share repurchases.”

Final Thoughts

Dividends provide information about earnings.  Dividend increases do the following:

  • Confirm past growth
  • Signal potential future growth

Dividend cuts, of course, signal the opposite.  That’s why the sell rules of The 8 Rules of Dividend Investing classify a dividend cut as an immediate sell – it shows the company is in decline.

In the final analysis, dividends matter.  Dividend history matters.  Dividend growth matters.  Investors who pay attention to dividends are following the actual cash payments a business makes.  Fraudulent firms simply cannot pay dividends for long.

While the evidence in this article is compelling, it’s also important to note that investing exclusively in high payout ratio stocks is riskier (if you care about dividend income) than medium payout ratio stocks.

Altria (MO) and Philip Morris (PM) have high payout ratios – and very stable earnings.  They are the exception rather than the rule.  If a company has a high payout ratio coupled with volatile earnings, or a long trajectory of declining earnings, it is far from a safe dividend play.

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Sure Dividend is designed specifically to simplify the process of investing in high quality businesses with shareholder friendly managements for individual investors. Sure Dividend takes a quantitative approach to this task, while providing qualitative analysis backed up by fundamentals. The Sure Dividend approach uses The 8 Rules of Dividend Investing to simplify the process of investing in high quality dividend growth stocks.
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