The Relationship between Dividend Payout and Price to Earnings

Abstract

Using a large database of all S&P 1500 index firms spanning an 88-quarter period from 1995 through 2016, we document that market cap (firm size), book-to-market ratio (a proxy for market perception of (inverse of) growth potential) and industry all matter for determining PE levels as a function of payout levels. In particular, current-period dividend payout is significantly and positively correlated with next period Price-to-Earnings (PE) ratio for high market cap firms, and significantly and negatively correlated for high book-to-market firms. However, once the PE levels are determined, current period dividend payout change is significantly and negatively associated with next period PE change. We find evidence supporting an argument that an increase in current period payout signals reduced investment opportunities and increased risk, which reduce PE ratios. Thus, modeling determinants of PE must take into account industry, size, risk and market perception of growth potential for a firm.