What Determines the Aggregate Dividend-Price Ratio? Earnings Versus Dividends

Abstract

In an efficient market, prices should vary only if investors change their expectations about cash flows, discount factors, or both. Prior research showed that dividend yield varies mostly due to variation in expected returns, and contains little information about cash flow. This literature concentrates on dividend growth variation as cash flow information. However, according to Miller and Modigliani (1961) with no taxes, given earnings, dividends are strictly a financing decision and should not affect prices. Consistent with the dividend-policy irrelevance hypothesis, this paper shows that variation in expected profitability growth explains as much as 70% of the variation in the dividend yield. Thus, the dividend yield contains information about cash flows in terms of earnings, not dividends. In addition, this paper finds evidence consistent with a permanent shift in the dividend yield in the 90s. Controlling for this permanent shift, the results indicate that the dividend yield has not lost its ability to predict returns.