Dividend increases and future earnings

Abstract

We examine the relation between dividend increases and unexpected changes in future earnings. This issue has been the subject of numerous empirical studies. However, the extant evidence on this issue is inconclusive. We allow for the fact that investor demand for dividend paying stocks is time-varying and the market pays a premium for such stocks when the demand is high. Moreover, when the dividend premium (DP) is high, dividend increases could be due to managers catering to high demand for dividends by investors. We find that when the DP is low, there is a significant positive relation between dividend increases and unexpected future earnings changes, consistent with the signaling theory of dividends. However, when the DP is high, the relation between dividend increases and unexpected future earnings changes is insignificant. This finding suggests that when the DP is high, managers increase dividends primarily to cater to investors’ demand for dividends rather than to signal an increase in the future profitability of the firm. Finally, as is the case with prior studies, we find an insignificant relation between dividend increases and unexpected changes in future earnings when we constraint the relation to be constant over time.