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What do dividends tell us about earnings quality?

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Abstract

Over the past 30 years, there have been significant changes in the distribution of earnings—cross-sectional variation has increased, with increasing left skewness—as well as in corporate payout policy, with many fewer firms paying dividends and the emergence of stock repurchases. We investigate whether the informativeness of payout policy with respect to earnings quality changes over this period. We find that the reported earnings of dividend-paying firms are more persistent than those of other firms and that this relation 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. These results do not hold as strongly for stock repurchases, consistent with them representing less of a commitment than dividends.

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Notes

  1. Miller and Modigliani (1961, p. 430) state that “…where a firm has adopted a policy of dividend stabilization…investors are likely to (and have good reason to) interpret a change in the dividend rate as a change in management’s views of future profit prospects for the firm”.

  2. The terms “information content of dividends” and “dividend signaling” tend to be used interchangeably in the literature, which is discussed further in Sect. 2.

  3. As discussed below, we also consider the informational role of repurchases, widely considered to be an alternative mechanism for paying out earnings.

  4. One of the recommendations in Richard Breeden’s report on the accounting and corporate governance problems at WorldCom is for the company to pay out at least 25% of net income each year as a regular cash dividend (Breeden 2003). The report says in this regard that “dividends are another method of gauging the reality of reported earnings” and that “significant differences between the levels of reported earnings and the availability of cash for dividends would eventually be a red flag of potential problems” (pp. 127–129).

  5. A number of definitions of earnings quality exist. We believe that the persistence of earnings is well accepted as a measure of earnings quality (e.g., Penman 2001) and captures salient features of the underlying construct. Dechow and Schrand (2004, p. 5) define a high quality earnings number as one that “…accurately reflects the company’s current operating performance, is a good indicator of future operating performance, and is a useful summary measure for assessing firm value”. We examine the relation between this measure of earnings quality and another prominent measure, the extent to which earnings are comprised of cash flows versus accruals (Sloan 1996; Richardson et al. 2005), later in the paper. Under another definition that we see as unlikely to be related to firms’ payout policy, timely loss recognition is interpreted as evidence of earnings quality (e.g., Basu 1997; Ball et al. 2003; Watts 2003).

  6. Aggregate Compustat earnings for 2001 were negative $69 billion, with 52% of firms reporting losses (Table 1). See also Hayn (1995), Basu (1997), Givoly and Hayn (2000), DeAngelo et al. (2004), Joos and Plesko (2005), Klein and Marquardt (2006).

  7. In fiscal 2000 over half of aggregate Compustat earnings are due to the 25 firms reporting the largest earnings (DeAngelo et al. 2004).

  8. In general, Skinner (2008) provides evidence to support the idea that repurchases are now used as a substitute for dividends. He shows that dividend policies have become increasingly conservative, with increases in dividends becoming smaller and less frequent and that many dividend payers now use repurchases to pay out transitory increases in earnings. He also shows that repurchases are linked to current and past earnings in a manner similar to dividends under the Lintner model, which supports the idea that, like dividends, repurchases are used to pay out earnings.

  9. For summaries, see Allen and Michaely (2002) or DeAngelo et al. (2008). Relevant papers include Watts (1973), Penman (1983), Healy and Palepu (1988), Leftwich and Zmijewski (1994), DeAngelo et al. (1996), Bernartzi et al. (1997), Nissim and Ziv (2001), Grullon et al. (2005).

  10. The increasingly conservative nature of dividend policy may be related to covenants that make dividends a function of retained earnings in bond covenants, to the asymmetric incentives in these contracts, and to the associated conservatism in reported earnings (e.g., see Ball et al. 2003; Watts 2003).

  11. Brav et al.’s (2005) survey indicates that the “stability of future earnings” and “a sustainable change in earnings” are two of the three most important factors in determining firms’ dividend policies. (The other is “maintaining consistency with historic dividend policy”—see their Table 7, which lists 17 separate factors.) An alternative way of thinking about the hypothesis is that dividends provide information about the variability/risk of the firm’s earnings distribution. Viewed in this way, the argument is related to that of Grullon et al. (2002), who argue that dividends provide information about changes in the systematic risk of firms and in particular that dividend increases signal firm maturity. See also Chen et al. (2007), who argue that changes in dividends capture changes in the information risk that is associated with the firm’s accrual quality and find that this information risk is priced.

  12. This idea is also tested by Caskey and Hanlon (2005), who investigate whether dividends are associated with the likelihood that the firm’s management will engage in accounting fraud (i.e., dividends are a credible signal that the firm’s earnings are not fraudulent).

  13. Following Banyi et al. (2008), we measure repurchases as stock purchases from Compustat (item #115). As discussed by Banyi et al. (2008), a number of measures of repurchases are used in the literature. They argue that using the Compustat measure of stock purchases is the most reliable of these measures. Fama and French (2001) use a more complicated algorithm based on the difference between stock purchases and stock issuances (#108) from the statement of cash flows and the change in treasury stock. As it turns out, however, the choice does not matter a great deal for our analyses: we have performed our analyses using both measures without much difference in the results.

  14. Corporate law, which varies by state of incorporation, can restrict a firm’s ability to pay a dividend, potentially creating a link between payout policy and losses. The majority of firms in the sample are incorporated in Delaware or New York. Delaware law allows the payment of a dividend out of surplus or, if there is no surplus, net profits from current and preceding years. New York permits the payment of dividends out of surplus as long as the net assets after the payment are at least equal to the stated capital (Wald and Long 2007). Thus, payout restrictions help explain why firms with multiple losses are less likely to pay dividends.

  15. The 50% definition is arbitrary; our main results do not change very much when somewhat different fractions are used.

  16. To verify this we have estimated logit regressions that regress the likelihood of paying a dividend on earnings deflated by total assets, a loss dummy, and an interaction between these variables. The coefficient on the interaction term tests whether the slope on earnings is larger when the firm reports a loss. Our results generally show that the coefficient on earnings is reliably positive (higher earnings increase the likelihood of dividends), the coefficient on the loss dummy is reliably negative (losses reduce the likelihood of dividends), while the coefficient on the interaction term is reliably positive (the slope is higher for losses than positive earnings). The exceptions are in the first subperiod (interaction negative and insignificant) and in the third subperiod (earnings variable positive and insignificant). The result on the interaction term is analogous to the Basu (1997) result on asymmetric timeliness because it indicates that dividends respond more to losses than to positive earnings. Results are similar for repurchases, although for these regressions the interaction is never reliably positive.

  17. These probabilities are based on the estimated logit regressions reported in Table 3. For example, in the first subperiod the estimated probability of a dividend when there is not a loss is e0.753/(1 + e0.753) = 0.68.

  18. Five percent is obtained by multiplying the fraction of dividend payers’ losses by the fraction of those losses that are not due to special items (0.44 × 0.12 = 0.053 for 2000 through 2005 and 0.59 × 0.10 = 0.059 for 1995 through 1999).

  19. For example, Sloan (1996) reports a coefficient of 0.84 using similar methods.

  20. We use dividend payout ratios rather than dividend yields to calibrate the magnitude of dividends because the dividend literature (based on Lintner 1956) suggests that managers think about their firms’ dividend policy in payout ratio terms, i.e., as a fraction of earnings rather than stock price.

  21. We exclude firm/years with negative payout ratios (dividend payers that report losses) from these tests because it is not obvious how to characterize these payout ratios. However, we have also run the tests in Table 5 after including negative payout ratios in the highest payout ratio portfolio with similar results.

  22. For the 1974 through 1983 period, median payout ratios for the dividend payer portfolios are 0.094, 0.196, 0.289, 0.411, and 0.697. There is modest evidence that the cross-sectional dispersion of payout ratios increases over time; the medians are 0.084, 0.192, 0.290, 0.421, and 0.826, respectively for the 1994 through 2005 period. The median payout ratios for each of the portfolios for the intermediate subperiod fall between those of these two subperiods.

  23. These results suggest that dividend payers are a relatively homogeneous group, in that they have similarly persistent earnings. As indicated above, all dividend payers tend to pay economically meaningful dividends (80% have payout ratios of 10% or more), so it could be that once earnings quality is sufficient to support regular dividends, it has no incremental effect on payout.

  24. We classify firms as paying regular dividends if they pay dividends in every year of a given subperiod and as making regular repurchases if they make repurchases in half or more of the years of a given subperiod. (Occasional repurchasers are firms that make repurchases in less than half of the years of a given subperiod.) This follows the evidence in Skinner (2008) that firms tend to make repurchases less frequently than dividends.

  25. Another way of combining firms’ dividend and repurchase decisions is to compute an overall payout ratio (i.e., sum dividends and repurchases for the year and divide by earnings) and sort the observations into portfolios based on these payout ratios. We have reperformed the tests reported in Table 5 using this alternative payout measure with similar results to those reported in that table.

  26. An additional motivation for controlling for firm size in these tests is that the results in Table 5 could be confounded by firm size. That is, there could be a positive relation between payout ratios and earnings persistence, but the tests in Table 5 failed to detect the relation because size is negatively related to payout ratios and positively related to persistence. In fact, payout ratios are positively related to size in our data. For example, for the five size portfolios, we find mean payout ratios of 0.115, 0.183, 0.229, 0.297, and 0.384 (0.036, 0.155, 0.178, 0.179, and 0.434) for the 1974 through 1983 (1994 through 2005) subperiod.

  27. See also Richardson et al. (2005), who link accrual reliability to earnings persistence more explicitly.

  28. The large majority of firms that pay dividends pay economically meaningful dividends. When we divide dividend payers into quintiles based on payout ratios, we find that the median payout ratio for the lowest payout quintile is 8–9%, implying that well over 80% of dividend payers pay out in excess of 10% of earnings and that many dividend payers pay out well in excess of this amount (the median payout ratio is around 30%).

  29. Chetty and Saez (2005) report that the number of dividend payers increased after the dividend tax cut introduced in the Jobs and Growth Tax Relief Reconciliation Act of 2003.

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Acknowledgments

We are grateful to two anonymous referees for comments. Earlier versions of this paper benefited from comments by workshop participants at Columbia (Burton Workshop), the London Business School Accounting Symposium (especially Peter Pope, the discussant), Michigan, MIT and Washington University as well as Ray Ball, Dan Bens, Harry DeAngelo, Linda DeAngelo, Gene Fama, Mei Feng, Rich Frankel, Gene Imhoff, Doron Nissim, and Paul Zarowin.

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  1. University of Chicago Booth School of Business, 5807 South Woodlawn Avenue, Chicago, IL, 60637, USA

    Douglas J. Skinner

  2. Harvard Business School, Soldiers Field, Boston, MA, 02163, USA

    Eugene Soltes

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Correspondence to Douglas J. Skinner.

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Skinner, D.J., Soltes, E. What do dividends tell us about earnings quality?. Rev Account Stud 16, 1–28 (2011). https://doi.org/10.1007/s11142-009-9113-8

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