I thought the investors out there would appreciate this one…
There’s plenty of evidence out there that, despite popular belief, high dividend yields and payout ratios indicate high future earnings growth rates.
One reason for this is that dividends are sticky and when a management commits to a dividend increase they are constraining future cash flows. Therefore, before committing to a dividend increase management must be confident about the firm’s future earnings power (i.e. the firm’s ability to grow earnings).
Moreover, a firm that restricts its ability to reinvest cashflows must pick from only the highest NPV projects. Therefore, the constraint on retained earnings actually increases the efficiency of the firm.
Here’s a classic paper by Robert D. Arnott and Clifford S. Asness: Surprise! Higher Dividends
= Higher Earnings Growth
Abstract
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.
