the information content of dividend hypothesis: a permanent income approach

THE INFORMATION CONTENT OF

DIVIDEND HYPOTHESIS:

A PERMANENT INCOME APPROACH

KENNETH DANIELS, TAI S. SHIN and CHENC F. LEE

ABSTRACT

The “information content cited the finance The con-

tent of a firm-specific hypothesis which contends that managers firm

dividend the firm’s future earnings. and Modigliani (1961)

suggested dividends may serve for future earnings, if earnings consist of permanent and

and if dividends depend on permanent earnings. This study decomposes the cur-

rent earnings into permanent and the Kalman filter. Empirical

from &anger’s test of causality show a more robust relationship and permanent

earnings compared and current earnings. Dividends for half

the sample.

Economists have long been puzzled by why corporations pay dividends and why individu- als desire dividends. Referring to “The Dividend Puzzle,” Black (1976) questioned why dividends exist at all. One possible explanation to the puzzle is that dividends contained information about a firm. For example, Miller and Modigliani (1961) suggested that a

Direr/ cdl c.orr~spon~l~,lce lo: Kenneth Daniels, Virginia Commonwealth University, School of Business.

Richmond. Virginia 2X284-4000; Tai S. Shin, Virginia Commonwealth University; Cheng F. Lee, Rutgers

University at New Brunswick.

International Review of Economics and Finance, 6(l): 77-86 Copyright 0 1997 by JAI Press Inc.

ISSN: 1059-0560 All rights of reproduction in any form reaervcd.

77


change in a firm’s dividend may cause significant movement of a firm’s market price, and

this may be reflective of the informational content of dividends. The information content of dividend hypothesis, hereafter referred to as the informa-

tion content hypothesis, is a firm-specific hypothesis which contends that managers of a firm use the dividend to signal asymmetric information about the firm’s future earnings.

Early approaches of the information content hypothesis investigated whether an unexpected change in dividends could improve the prediction of future earnings. Watts (1973) investigated whether an unexpected change in dividends at time t could have any explanatory power for the actual change in earnings at time t + 1, and concluded that the information content of dividends was trivial. Laub (1976) compared the mean

squared forecast errors of several earnings forecasting models, with and without lagged dividend information, and concluded that the inclusion of dividend information resulted in lower forecast errors.

Another approach of the information content hypothesis investigates the relationship

between unexpected dividend changes and stock prices. It is assumed that any forecast

of future earnings with dividends should be reflected in stock prices at or prior to the announcement of the dividends if the stock market is efficient. Dividend studies such as Fama, Jensen, and Roll (1969), Pettit (1972), Charest (1978), Aharony and Swary (1980) Divecha and Morse (1983), Asquith and Mullins (1986), Fehrs, Benesh, and Peterson (1988), Jayaraman and Shastri (1988) provide evidence for the information

content hypothesis by examining the immediate price reaction to unexpected dividend changes.

The literature on the information content hypothesis has recently focused on the type of

information that is revealed through the dividend announcement. Studies such as Brickley (1983), Ofer and Siegel (1987) document a significant relationship between dividends and expected future earnings. Manakyan and Carroll (1990) documented a significant relationship between dividends and unexpected earnings. Gweon, Lee and Shin (1993) find that

there exists a unidirectional causality from earnings to dividends, not vice versa. Conse- quently, the information content hypothesis should be rejected. Miller and Rock (1985) conclude that the announced dividend does convey information about the firm’s future earnings but only indirectly. In their argument the dividend announcement establishes the firm’s current earnings and the current earnings serves as a basis for future earnings estimates.

The empirical evidence documenting the information content hypothesis has provided

mixed results. The focus of this study is on the type of information that is conveyed by the dividend and to identify how much marginal information, if any, is conveyed by the divi-

dend over and above that of the earnings. The information content hypothesis implies that dividends convey information about future earnings.

In addition, any causality studies of dividends and future earnings has examined the relationship in the aggregate, and the information content hypothesis cannot be tested unbiasedly with aggregate data. Also, the hypothesis is based upon future earnings there- fore any study must explicitly address the measurement of future earnings. Section II presents the information content hypothesis. Section III discusses the theoretical and empirical determination of permanent earnings, while section IV discusses the empirical

estimation of permanent earnings. Section V presents the empirical results and concluding remarks are presented in Section VI.

Dividend Hypothesis 79

II. INFORMATION CONTENT HYPOTHESIS

The information content hypothesis implies that dividends convey information about the

firm’s future earnings. Specifically, the objective is to tests the hypothesis that knowledge

of current and past dividends enables a better prediction of future earnings than with cur-

rent and past earnings alone. Following Gweon, Lee and Shin (1993) the “economically

rational” investor would utilize dividends to forecast future earnings if the additional infor-

mation provides less expected mean-square forecast error than its own his- -- tory:o*((EIE, D) < &II?),

-- o*((EIE, D) < o*E@), (1)

-- where o*(EI E, D) is the minimum-mean-square forecast error of earnings given both past

values of earnings and dividends and o*( E I E) is the minimum-mean-square forecast error of earnings given past earnings only. However, equation (1) exactly corresponds to the condition first set forth by Granger (1969) under which one can say D “causes” E.

Granger’s definition of causality states that D causes E if past values of D can be used to

predict E more accurately than simply using the past history of E. This definition is, of course, conditional on the assumption that all variables except E and D may be excluded

from consideration without giving rise to spurious causality. The information content hypothesis expects to find a causal relationship from divi-

dends to future earnings. One problem is that the future earnings are not directly

observable. Miller and Modigliani (1958, 1959, 1961, 1963, 1966) have argued that a firm’s market value is determined by its permanent earnings, not by the transitory earn-

ings. In addition they suggested that dividends may serve as a surrogate for future earnings, if earnings consist of permanent and transitory components, and if dividends depend on permanent earnings. The adaptive expectations model, which is a version of

the information content hypothesis, hypothesizes that current dividends are related to

the expected long-run earnings or permanent earnings. Solomon (1963), Laub (1976) and Pettit (1972, 1976) indicated that dividends convey information about future earn-

ings prospects and that changes in dividends is a result of a change in the expectation

of long-run earnings. Ang (1975) in his study of twenty industries found that the infor-

mation content hypothesis was rejected in the long-run as the past data failed to

confirm the ability of dividends changes to predict long-run earnings changes. How-

ever, Lee and Primeaux (1991) use disaggregated earnings and dividends data of industrial firms to illustrate that firms allocate permanent earnings and transitory earn-

ings between dividend payments and retained earnings. They find that the dividend-

payment behavior is explained more adequately by the permanent earnings of the firm. The combined arguments of Miller and Modigliani (1958, 1959, 1961, 1963, 1966) and the others provide insight into the market’s valuation of the firm’s future earnings.

Future earnings are not directly observable but the dividend may serve as a credible proxy for the future earnings if there exist a significant relationship between dividends and permanent earnings. In this sense the dividend directly conveys information about the firm’s future earnings by confirming the permanent earnings of the firm. This

hypothesis can be tested from equation (2).

80 KENNETH DANIELS, TAI S. SHIN and CHENC F. LEE

EC, = b,+ C b,Ei t-k+ C CkD;.t-k+e;,t, k=l ’ k= I

where ET:, equals the permanent earnings of each firm, Ej, r_kequak the earnings of each firm,D. I,r_k equals the dividends of each firm and, ei f is an independent white-noise error process. The null hypothesis that dividends do not cause permanent earnings is:

He: cl = c2 = c3 = . c, = 0. (3)

If the null hypothesis, which is a partial F-test, is not rejected then a firm uses its dividends to convey information about its permanent earnings. Following Manakyan and Carroll (1990), we assume the impact of new information contained in a variable would decay over eight quarters.

Previous empirical work such as Manakyan and Carroll (1990) and Gweon, Lee, and Shin (1993) tested the information content hypothesis by equation (4).

E;,, = bo+ C b$i t-k+ C dkD;,,-k+ei.r’ k=l ’ k= I ,

where Ei t equals the current value of a firm’s earnings. The null hypothesis that dividends do not cause earnings is:

H,: d, = d2 = d3 = . . d, = 0. (5)

A comparison of equation (2) and equation (4) indicate that the dividend may reveal dif- ferent types of information. Equation (2) supports the hypothesis that the dividend indirectly reveals information about the firm’s future earnings by signalling the firm’s permanent earnings. Equation (4) supports the hypothesis of Miller and Rock (1985) that the dividend indirectly reveals information about the firm’s future earnings by signalling the firm’s current earnings.

In each hypothesis the choice of the dependent variable is a critical choice because it becomes the proxy for the future earnings of the firm. It seems reasonable that the actual earnings should provide an unbiased estimate of the future earnings but this assumption may ignore the future information the manager of the firm possesses about future earnings prospects. The permanent earnings of the firm takes into account the future earnings prospects of the firm and this may cause it to be a better proxy of the firm’s future earnings.

III. THEORETICAL AND EMPIRICAL DETERMINATION OF THE FIRM’S PERMANENT EARNINGS

Any study of the information content hypothesis must reconcile the fact that future eam- ings are not directly observable. In this study we suggest permanent earnings as the proxy for the future earnings of the firm. In the permanent-income hypothesis Milton Friedman (1957) used the concept of permanent income to explain how consumers adjust their con-


sumption expenditures. The permanent-income hypothesis is readily acceptable to the

information content hypothesis. The information content hypothesis infers that dividend is not a function of current earn-

ings but a function of future earnings, which will be proxied by permanent earnings in our

study. The level of permanent earnings earned by a firm determines the dividend it can pay

out to stockholders. Permanent earnings is not an average of current and past earnings of

the firm but a forward-looking mean that takes into account the future earnings prospects of

the firm. Permanent earnings represents the long-run earnings position of the firm. Current earnings is divided into two components:

where Ei t is the current earnings of the firm, E: the permanent earnings of the firm, and

ETi,, the transitory earnings of the firm. Transitory earnings may be positive or negative,

and current earnings will differ from permanent earnings by the amount of transitory eam-

ings. A business earns transitory earnings from windfall profits or nonrecurring gains or

losses from any source. For example, in the early 1980’s oil companies earned transitory

earnings from the increased prices they received from selling products made from crude oil

produced domestically. Firms incur negative transitory income if they experience an unin-

sured catastrophic event such as the destruction of a plant by a disaster of any kind or an

unexpected strike by employees. The transitory components of earnings, positive and negative, should cancel out over the permanent-earnings time horizon. Transitory components,

however, are always present during shorter time periods. Our interest lies with permanent earnings because it represents the long-run earnings

position of the firm. The Kalman filter algorithm allows us to compute the permanent eam-

ings with the smoothing estimate. For a discussion of the Kalman Filter see Shumway and

Stoffer (1982). Following Clark (1987) the earnings of each firm was decomposed into permanent and

transitory components as follows:

E; f = E;, + ETt.

Et = B E! 1, t 1 +di,t+Wi,ty

di l = di I_ 1 + ui 1’

p(L)ET = v. 1, t I, f’

(7)

(8)

(9)

(10)

where w’ ,, ,, Ui, t and vi, t are independent-white-noise processes with variances W, U,and V, respectively, while p(L) is a finite polynomial in the lag operator L. The intercept of the

permanent earning function is represented by di, t. Equation (8) specifies the permanent earnings as a local approximation to a linear trend.

Innovations in the level of permanent earnings are given by Wi, I, while innovation in its

first difference are given by u;, t. Equation (10) specifies the stationary transitory earnings as a finite autoregression rather

than a more general ARMA process with moving average terms. Elimination of moving

average terms simplifies parameter estimation with little cost in terms of model fit.


IV. ESTIMATION OF PERMANENT EARNINGS

The unobserved components model represented by equations (7)-( 10) can be estimated by

state space techniques once the likelihood function has been specified in terms of the model coefficients. The assumption of normality for the error terms allows maximum likelihood techniques to produce the estimated parameters. Assuming that transitory earnings follow

a first-order autoregression the state-space model is as follows:

EC* I 1 di,t+l =

El*

B, 1 0

0 1 0

0 OB,

E(t

X I di, t

E[t- 1

Wi, t _I1 + ‘i,t

“i, t

(11)

(12)

The maximum likelihood estimates of the parameters in the system can be found by

applying the Kalman Filter algorithm recursively. The smoothing algorithm of the Kalman Filter involves a backcast over the data from t =

N back to t = 1, which produces smoothed estimates that are based on the entire sample of

information. We use the smoothed estimates of permanent earnings in this study because it

incorporates a forecast of future earnings. We believe this forward-looking approach

allows permanent earnings to capture the behavior of future earnings.

V. THE EMPIRICAL RESULTS

The quarterly earnings per share data were randomly obtained for thirty firms from 1975

QII to 1990 QII using the Compustat tapes. Earnings and dividends per share were adjusted for stock splits. The following criteria were used to select the sample of firms.

1. All firms are listed on the NYSE and Standard and Poor 400. 2. The fiscal year ended on December 3 1. 3. No missing observations over the sample period.

In his dividend studies, Laub (1970, 1976) investigated thirty corporations. The postse- lection bias in samples of this nature taken from Compustat has been noted in the literature. Watts (1973) recognizes that firms which meet these criteria tend to be larger and less risky than the average firm. However, he maintains that these firms are interesting in their own right, since they represent a large proportion of the total corporate sector of the economy.

Moreover, he does not believe that the dividends of these firms convey more or less information.


Following Manakyan and Carroll (1990) all variables were deflated by the 1982 GNP

deflator and it was assumed that the impact of new information contained in lagged divi-

dends and earnings per share would decay over eight quarters. The length of lag is

somewhat arbitrary. Sargent (1976) included in his regression on the relationships between

unemployment and various causal candidates such as money supply, government surplus,

and others, four lagged values of the dependent variable and six lagged variables of the

other variable. Feige and Pearce (1979) set the lag lengths at four for the causal variable

and four or eight for the dependent variable in their study on money and income. Both

lengths in their tests gave the similar results. In his study of money-income causality in the

United Kingdom, Cuddington (198 1) included four lagged values of dependent and inde-

pendent variables based on his preliminary tests on the lengths which had shown no

statistical significance of the lags five through eight. However, the length should be set at

least to the extent that regression residuals are not serially correlated. The information content hypothesis infers that the dividend directly conveys information

about the firm’s future earnings by confirming the permanent earnings of the firm. This

hypothesis can be tested from equation (13).

8 8

EPt = b,+ c bkEi I-k+ c CkD;,+k+e;,f k=l ' k= I

(13)

The null hypothesis that dividends do not cause permanent earnings is:

H,: c, = c2 = c3 = . . c8 = 0. (14)

The alternative hypothesis is that the dividend indirectly reveals information about the

firm’s future earnings by signalling the firm’s current earnings. This hypothesis can be tested by equation (15).

8

Ei,t = bo+ i bkEi,lpk+ 1 dkDi,,-kcei,f: k= I k= 1

(15)

where Ei f equals the current value of a firm’s earnings. The null hypothesis that dividends

do not cause earnings is:

H,: d, = d2 = d, = t.. d, = 0. (16)

Table 1 reports the results of the partial F-tests and the respective adjusted R2. In general

equation (13) is more robust than equation (15) as indicated by the higher adjusted R2 for

each firm except Merck. Also, the distributed lags of past earnings and dividends are well

behaved although not reported. Comparison of the partial F-statistics in Table 1 indicates that dividends “cause” permanent earnings for fifteen of the thirty firms. However, divi-

dends “cause” current earnings for only five firms. It seems the additional information that

is contained in the dividends is obscured by the additional volatility of earnings which is

indicated by the lower R2s for equation (15). This indicates the dividend is not a reliable

indicator of short-term earnings performance. However, a more robust relationship exist


Table 1. Granger Direct Tests

Firms Eq. 14 Adj. R’ Eq. I6 Adj. R2

1. ALLIED SIGNAL

2. AMERICAN BRANDS

3. ANHEUSER BUSCH

4. AVON

5. BETHLEHEM STEEL

6. BORDEN

7. CAPITAL CITIES

8. CATERPILLAR

9. CHAMPION

10. CHEVRON

11. CINCINNATI MILACRON

12. COPPERWELD

13. CROMPTON & KNOWLES

14. DONNELLY

15. DOW CHEMICAL

16. EASTMAN KODAK

17. EXXON

18. FOXBORD

19. GENERAL ELECTRIC

20. INCO

2 I. INGERSOLL-RAND

22. INTL. PAPER

23. JOHNSON & JOHNSON

24. KERR-MCGEE

25. MAYTAG

26. MERCK

27. PHILIP MORRIS

28. FLEMING COMPANIES

29. ALCAN ALUMINUM

30. GOODYEAR

9.26* 0.486

4.54* 0.840

5.43* 0.658

2.67* 0.860

0.43 0.34 1

1 .I4 0.875

6.29* 0.945

0.98 0.832

0.45 0.754

42.98* 0.986

19.88* 0.986

0.68 0.950

1.82 0.845

1.64 0.820

4.91* 0.959

0.11 0.798

32.87* 0.986

2.95* 0.968

5.37‘ 0.945

0.18 0.898

2.18 0.895

1.14 0.829

0.75 0.886

3.38* 0.934

4.74* 0.835

0.30 0.636

4.94* 0.650

5.52* 0.889

1.66 0.959

0.25 0.519

1.45 0.304

1.97 0.834

1.65 0.647

0.8 1 0.343

0.43 0.129

0.49 0.552

1.51 0.415

0.72 0.752

0.03 0.419

2.01 0.814

1.48 0.625

2.36* 0.774

0.56 0.306

2.38* 0.790

0.41 0.703

0.41 0.749

3.06* 0.83 1

2.13 0.697

5.67* 0.863

0.2 I 0.272

1.24 0.635

0.17 0.243

2.14* 0.836

0.78 0.426

2.09 0.778

0.74 0.647

I .77 0.552

1.85 0.760

0.70 0.799

0.22 0.229

Norr.~: I. The * represents significance of the partial F-atistic at the S-percent level.

2. Eq. 14 reprcscnts a Gangcr-causdity tat\ from diwdends to permanent earning\

3. Eq I6 rcprescnts a Grangcr-causality tat\ from dividend\ tv earning\.

between the dividend and the long-run earnings performance as measured by the perma-

nent earnings.

VI. CONCLUSIONS

Previous empirical research of the dividends-earnings relationship has failed to document

conclusively a causal relationship from dividends to future earnings. This is due perhaps to

the use of aggregate data to test a firm-specific hypothesis and the use of current earnings, which is a measure of short-run earnings performance, as a proxy for the future earnings of the firm. In this study it was shown that dividends “caused” permanent earnings for half the

sample, while the causality study from dividends to current earnings failed to detect a

causal relationship for more than eighty percent of the sample. We attribute the improved


performance to an analysis of the hypothesis at the firm level and a better proxy of the

future earnings, The direct estimation of permanent earnings allows the information con-

tent of dividend hypothesis to be tested directly. We provide empirical evidence that the

dividend may serves as a surrogate for future earnings, if earnings consist of permanent and

transitory components, and if dividends depend on permanent earnings.

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the information content of dividend hypothesis: a permanent income approach

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