International Evidence on the Payout Ratio, Earnings, Dividends, and Returns

Recent evidence for the U.S. market has shown that, contrary to popular wisdom, the greater the proportion of earnings paid out as dividends, the greater the subsequent real earnings growth. This study extends previous work by examining whether a similar relationship exists in 11 international markets and by considering the role the payout ratio plays in explaining future real dividend growth and returns. Higher payout ratios do indeed lead to higher real earnings growth—but not to higher real dividend growth. This information has limited use, however, for predicting future returns. Although the payout ratio has long been of importance to corporate finance researchers, it has been relatively neglected in the asset-pricing and prediction literature, despite market fascination with investment strategies based on dividends and earnings (e.g., the “Dow 10”). Recent research has established the somewhat surprising result that higher aggregate payout ratios for the United States are associated with higher future earnings growth. This finding offers support for theories that view dividends as signals for earnings expectations.Our article contributes to the literature by investigating whether similar conclusions can be drawn about 11 major international markets and by extending the analysis to consider the relationship between payout ratio and returns, which we believe to be important because returns are the ultimate focus of portfolio managers and investment strategists. For each country, we used monthly values of the dividend yield, earnings yield, a retail price index or consumer price index (as appropriate), and the stock market index level. We also constructed a return series for each country's index.We investigated the explanatory power of the following variables: payout ratio, dividend yield, earnings yield, lagged dividend growth, and lagged earnings growth. We examined three time periods (determined by data availability) and for the lagged variables used lags of 10 years, 5 years, and 1 year—depending on the length of the sample period.We found that, despite the different institutional, tax, and legal environments of the 11 countries, substantial reinvestment of retained earnings did not increase future real earnings growth, although it did produce faster real dividend growth. Investing in the countries with the higher payout ratios also resulted in higher earnings growth.Unfortunately, these findings did not translate to return predictability in a persuasive fashion: The results varied by country and time period. The notable exception was the U.S. market, where we found the payout ratio to be a significant variable in explaining subsequent 5-year and 10-year returns.Currently, the components of the S&P 500 are paying out around one-third of their earnings as dividends, well below the post-World War II average of 50-60 percent. Therefore, our findings suggest that the outlook for earnings growth in the next few years is ominous.