The adjustment of dividends to permanent earnings.

• Author: Chihwa Kao

1. Introduction

   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.(1) However, these studies have yielded puzzling results. Studies using the event-study 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 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 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 Lintner [19], Brittain [4], Fama and Babiak [6], and Lee, Wu and Djarraya [18]. Specifically, we introduce a formation process of permanent earnings expectations similar to that suggested by Nakamura and Nakamura [26], into the dividend model.(2) Unlike Nakamura and Nakamura [26], our model permits a direct test of market rationality. Furthermore, we introduce a more general specification of earnings expectations. The type of expectations formation proposed here is consistent with the rational expectations hypothesis developed initially by Muth [25] and tested by Mishkin [23], Hoffman and Schmidt [12], Gregory and Veall [10] and Lovell [20]. Our specification of expectations formation represents an improvement over the past work by Waud [33]. (3)

   Our empirical results have important implications for dividend models. Recently, rational signalling models proposed by Miller and Rock [22], and John and Williams [13] have been constructed to explain the information effect of dividends. These models show that dividends convey the manager's private information to the market and the market participants rationally revise their expectations for future earnings according to the dividend information released by the manager. However, there is to date no direct test performed at the corporate level on the rational expectations-permanent earnings hypothesis. Our main contribution is that we provide a direct joint test on both market rationality and the information contend of dividends.

   The remainder of this paper is dividend into five sections. Section II provides a fairly general treatment of the dividend adjustment process with a rational expectations-permanent earnings specification. Section III provides a test of rationality. Section IV discusses the estimation procedure. Section V reports our major empirical results. Section VI compares our model with others in the literature. Finally, section VII summarizes the findings of this paper.

2. Rational Expectations, Permanent Earnings, and the Dividend Adjustment Process.

   Consider the following partial adjustment model for dividends (1) [Mathematical Expression Omitted] where [Mathematical Expression Omitted] is the desired dividend payment in time t, [Lambda] is the speed of adjustment coefficient with 0

   Traditionally, the target dividend [Mathematical Expression Omitted] is linked to current earnings in the empirical investigation as in Lintner [19] and Watts [32]. It is commonly assumed that [Mathematical Expression Omitted] = [Upsilon] [Y.sub.t] where [Upsilon] is the target payout ration and [Y.sub.t] is current earnings. Given this relation, requation (1) can be rewritten as (2) [Mathematical Expression Omitted]

   There are two problems with this simple partial adjustment model. First, the model implicitly assumes that dividends are related to current earnings. However, it is more likely that managers would determine [D.sub.t] based on the estimate of permanent earnings in time t. Second, the partial adjustment model assumes that the lagged earnings will not affect current dividends. This assumption is not appropriate. Empirical evidence by Fama and Babiak [6] has shown that the likelihood of raising the current dividend per share increases as firms have consecutive earnings increases. In Fama and Babiak's study, 65.8 percent of the firms in the sample increase dividends in the next period when there is a one-period earnings increase. The proportion of the firms raising dividends increases to 74.8 percent when firms have two consecutive earnings increases; to 80.7 percent when firms have three consecutive earnings increases. Despite these findings, the possible effects of lagged earnings on the current dividends have been ignored by many previous dividend studies using the partial adjustment model.(5) In the following, we propose an alternative model to resolve these two problems.

   Lintner was one of the first to suggest that dividend changes are related to permanent earnings changes. Nakamura and Nakamura [26] and Marsh and Merton [21] provided some evidence to support this hypothesis. Healy and Palepu [11] also found that dividend initiations and omissions provide information to investors on earnings for several years subsequent to the dividend announcement. The results of these studies imply that managers have superior information to investors on future earnings. As such, managers will be able to form more precise estimates of permanent earnings. Managers would then increase dividends in response to an increase in permanent earnings.

   Following Nakamura and Nakamura [26] we assume that the desired dividends, [Mathematical Expression Omitted], are related to the permanent earnings [Mathematical Expression Omitted], according to (3) [Mathematical Expression Omitted] where [Upsilon] is the long-run target payout ratio, and (4) [Mathematical Expression Omitted] where [E.sub.t] is the conditional expectations operator given the information set I(t) available to the manager in period t, i.e., [E.sub.t] ([Y.sub.t]) = [Mathematical Expression Omitted] for j = 1,2,. . . . As in Nakamura and Nakamura [26] we assume that I(t) includes [Y.sub.t] the current earnings, and the dividend decision is made after the current earnings is known to the manager. The definition of a permanent variable as in (4) has been adopted in the literature. For instance, Flavin [7] used a similar specification in a study of the relationship between consumption and permanent income. In [Mathematical Expression Omitted] represents the present value of all future discounted earnings expected by the manager and therefore, is the intrinsic value of the firm expected by the manager in time t. The firm's permanent earnings perceived by the manager are stated as the return on the expected intrinsic value of the firm in time t. The parameters b and a in (4) are the manager's discount factor and the rate of return on the intrinsic value of the firm, respectively.

   Substituting (3) into (1) yields [Mathematical Expression Omitted] or (5) [Mathematical Expression Omitted]

   The model in (5) is similar to that in Nakamura and Nakamura [26]. In order to complete the dividend adjustment model, it is necessary to process of earnings generation. Assume that earnings [Y.sub.t] follows an autoregressive (AR) process of order M

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