The Adjustment of Dividends to Permanent Earnings

Abstract

A fundamental issue in corporate finance is whether dividend changes convey information about future earnings of the firm. There is an extensive literature in finance and accounting which discusses this issue.' However, these studies have yielded puzzling results. Studies using the eventstudy methodology and the cross-sectional regression approach have usually found a significant relationship between dividend changes and subsequent earnings. On the other hand, empirical studies based on time-series regression by Watts [32] and Gonedes [8] have found that dividends convey little information about subsequent earnings. Most of the previous studies have examined the relationship between dividends and reported earnings or the relationship between dividends and analyst earnings forecasts. However, as Nakamura and Nakamura [26] suggested, dividend changes may be related to the permanent earnings of the firm. If managers have superior information to investors on future earnings, they should be able to form more precise estimates of permanent earnings. Managers may then use dividends as an instrument to reflect their beliefs about the likely changes in permanent earnings. Thus, consistent with Lintner's [19] observations, an increase in current earnings which reverses in subsequent periods would typically not elicit a dividend change, whereas an increase in earnings that is expected to persist would lead to a dividend change. The use of reported earnings figures, rather than permanent earnings, in the empirical examination may explain the puzzling results documented in previous dividend studies. If managers indeed determine dividends based on their forecasts of permanent earnings, empirical investigation using either reported earnings or short-run earnings forecasts will be subject to a serious measurement error. This measurement problem could distort the empirical relationship in dividend-earnings studies. In this paper, we propose a permanent earnings model to explain the corporate dividend behavior. The model is an extension of the previous partial adjustment models of dividends by