Evidence on Payout Ratio

Recent evidence for the U.S. market has shown that, contrary to popular wisdom, the greater the proportion of earnings paid out as dividends, the greater the subsequent real earnings growth. This study extends previous work by examining whether a similar relationship exists in 11 international markets and by considering the role the payout ratio plays in explaining future real dividend growth and returns. Higher payout ratios do indeed lead to higher real earnings growthвЂ"but not to higher real dividend growth. This information has limited use, however, for predicting future returns. Arnott and Asness (2003; hereafter A&A) established the somewhat surprising finding that higher aggregate dividend-payout ratios in the United States are associated witb higher future earnings growth. This finding supports theories that view dividends as signals for earnings expectations. The Authors have extended the work of A&A and others in two main ways:

Authors investigated whether similar findings are evident in 11 major international markets.

Authors extended the analysis to the relationship between the payout ratio and returns, which we believe to be important because returns are the ultimate focus of portfolio managers and investment strategists. Although the payout ratio has long been of

importance to corporate finance researchers (e.g., Lintner 1956), it has been relatively neglected in the asset-pricing and prediction literature (see McManus, ap Gwilym, and Thomas 2004; ap GwiÐ'¬lym, Seaton, and Thomas, forthcoming 2005)вЂ" despite market fascination with investment strategies based on dividends and earnings (e.g., the "Dow 10" strategy).' A&A redressed this omission in the literature by examining the aggregate payout ratio for U.S. stocks since 1871 and its relationship to subsequent 10-year real earnings growth. They found a positive coefficient on tbe payout ratio in a simple linear regression for a variety of sub periods and suggested that the low payout ratio of 2001 would lead to low earnings growth in the following decade. In their analysis of 5-year earnings growth and a rolling 30-year period, they found that these results are robust.

Because dividends are "stickier" (more stable over time) than earnings, A&A also examined whether the phenomenon is actually reflecting mean reversion in earnings; a transient drop in earnings