A Direct Test Of The Dividend Catering Hypothesis

Why do CEOs decide to pay dividends?

That is an interesting question, and one that academics have been researching for years. Miller and Modigiliani in 1961 show that if one assumes perfect and efficient capital markets, and investors should have no preference as to whether or not a firm pays dividends.[ref] Note Miller and Mogidiliani also state that capital structure is irrelevant in other papers.[ref][ref]Some corporate finance literature tends to highlight that higher dividend payments reduce the CEO’s ability to spend capital on wasteful R&D projects.[ref]

However, (some) people care about dividends!

But are dividend paying stocks better investments? We show (along with other research papers and books) that examining more comprehensive measures of shareholder yield–such as the combination of dividends, net share repurchases, and net debt paydown–is more predictive of future returns.[ref]Stocks with higher shareholder yield performed better than those with lower shareholder yield in the past.[ref]

And yet, against the evidence, many investors still ask — “What is the dividend yield?”

And so maybe there is a human psychology component involved here!

A paper in 2004 by Malcolm Baker and Jeffrey Wurgler examines this question. They ask the following — do companies “cater” to investor demands for dividends? To test this idea, they examine 4 stock price-based measures of investor demand for dividend payers. They find the following:

  • When there is a high demand for dividends — non-payers tend to initiate dividends
  • When there is a low demand for dividends — payers tend to omit dividends.
  • So the paper finds that CEOs appear to be “catering” to investor demands (follow on research shows that fund managers engage in “juicing” their dividends). However, one can argue that the measures used in the paper may not truly capture the “demand” for dividends.[ref]Formally, they are the following: M/B, CU stock discount, abnormal announcement returns around initiations, and the difference of future stock returns between the VW portfolio of dividend paying firms and non-dividend paying firms.[ref]

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    Author: Travis Esquivel

    Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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