A Catering Theory of Dividends
ABSTRACT We propose that the decision to pay dividends is driven by prevailing investor demand for dividend payers. Managers cater to investors by paying dividends when investors put a stock price premium on payers, and by not paying when investors prefer nonpayers. To test this prediction, we construct four stock price-based measures of investor demand for dividend payers. By each measure, nonpayers tend to initiate dividends when demand is high. By some measures, payers tend to omit dividends when demand is low. Further analysis confirms that these results are better explained by catering than other theories of dividends. Copyright 2004 by The American Finance Association.
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ABSTRACT: This article explores the corporate dividend payment behavior of the Japanese chemicals industry firms. According to our empirical examinations, the Japanese chemicals industry firms do not cater to investors' dividend demands when they decide both their dividend initiations and continuations. Instead of catering factor, in this industry, our empirical examinations reveal that the determinants of corporate dividend policies are value-weighted size, value-weighted dividend yields, and value-weighted nonpayers' or payers' market-to-book ratio. In addition, although our cross-sectional tests generally imply the relations between corporate dividend payments and firm earnings, on an aggregate time-series basis, dividend initiations tend to decline corporate earnings in the following year in this Japanese industry. This evidence can be interpreted as the denial of the traditional signaling hypothesis of dividend policy in the Japanese chemicals industry firms.
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ABSTRACT: Many studies claim that aggregate managerial decision variables, such as aggregate equity issuance, predict stock or bond market returns. Recent research argues that these results may be affected by an aggregate time-series version of Schultz's (2003) pseudo market timing bias. We point out that the bias in question is actually a well-known small-sample bias whose importance can be estimated using standard simulation techniques. The estimates indicate that the bias is much too small to explain the predictive power of the equity share in new issues, corporate investment plans, insider trading, dividend initiations, or the maturity of corporate debt issues.
- International Research Journal of Finance and Economics 01/2008;
NBER WORKING PAPER SERIES
A CATERING THEORY OF DIVIDENDS
Working Paper 9542
NATIONAL BUREAU OF ECONOMIC RESEARCH
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We would like to thank Viral Acharya, Raj Aggarwal, Katharine Baker, Randy Cohen, Gene D'Avolio, Steve
Figlewski, Xavier Gabaix, Paul Gompers, Florian Heider, Laurie Hodrick, Dirk Jenter, Kose John, Steve
Kaplan, John Long, Asis Martinez-Jerez, Colin Mayer, Holger Mueller, Sendhil Mullainathan, Eli Ofek,
Lubos Pastor, Lasse Pedersen, Gordon Phillips, Raghu Rau, Jay Ritter, Rick Ruback, David Scharfstein,
Hersh Shefrin, Andrei Shleifer, Erik Stafford, Jeremy Stein, RyanTaliaferro, Jerold Warner, Luigi Zingales
and seminar participants at Dartmouth, Harvard Business School, London Business School, LSE, MIT, NBER
Behvioral and Corporate Conferences, NYU, Oxford, the University of Chicago, the University of Michigan,
the University of Rochester, and Washington University for helpful comments; John Long and Simon
Wheatley for data; and Ryan Taliaferro for superb research assistance. Baker gratefully acknowledges
financial support from the Division of Research of the Harvard Business School. The views expressed herein
are those of the authors and not necessarily those of the National Bureau of Economic Research.
©2003 by Malcolm Baker and Jeffrey Wurgler. All rights reserved. Short sections of text not to exceed two
paragraphs, may be quoted without explicit permission provided that full credit including ©notice, is given
to the source.
A Catering Theory of Dividends
Malcolm Baker and Jeffrey Wurgler
NBER Working Paper No. 9542
JEL No. G35
We develop a theory in which the decision to pay dividends is driven by investor demand. Managers
cater to investors by paying dividends when investors put a stock price premium on payers and not
paying when investors prefer nonpayers. To test this prediction, we construct four time series
measures of the investor demand for dividend payers. By each measure, nonpayers initiate dividends
when demand for payers is high. By some measures, payers omit dividends when demand is low.
Further analysis confirms that the results are better explained by the catering theory than other
theories of dividends.
Harvard Business School
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Boston, MA 02136
New York University School of Business
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New York, NY 10012-1126
Miller and Modigiliani (1961) prove that dividend policy is irrelevant to stock price in
perfect and efficient capital markets. In that setup, no rational investor has a preference between
dividends and capital gains. Arbitrage ensures that dividend policy is irrelevant.
Over forty years later, the only assumption in this proof that has not been thoroughly
scrutinized is market efficiency.1 In this paper, we present a theory of dividends that relaxes this
assumption. It has three basic ingredients. First, for either psychological or institutional reasons,
some investors have an uninformed, time-varying demand for dividend-paying stocks. Second,
arbitrage fails to prevent this demand from driving apart the prices of stocks that do and do not
pay dividends. Third, managers cater to investor demand – paying dividends when investors put
a higher price on the shares of payers, and not paying when investors prefer nonpayers. We
formalize this catering theory of dividends in a simple model.
The catering theory differs from the standard view of the effect of investor demand on
dividend policy. The standard view emphasizes the irrelevance of dividend policy to share prices
even when some investor clienteles have a rational preference for dividends. For example, Black
and Scholes (1974) write: “If a corporation could increase its share price by increasing (or
decreasing) its payout ratio, then many corporations would do so, which would saturate the
demand for higher (or lower) dividend yields, and would bring about an equilibrium in which
marginal changes in a corporation’s dividend policy would have no effect on the price of its
stock” (p. 2). This equilibrium intuition for dividend irrelevance can also be found in corporate
1 Allen and Michaely (2002) provide a comprehensive survey of payout policy research.
The catering theory and the clientele equilibrium theory differ on several key points. One
is that catering takes seriously the possibility that investor demand for dividends is affected by
sentiment. This adds a new and unexplored source of demand to the rational dividend clienteles
considered by Black and Scholes. Another difference is that the catering view focuses more on
the demand for shares that pay dividends, whereas the determinate supply response in a clientele
equilibrium view is the overall level of dividends. For example, we discuss the possibility that
managers cater to investors who categorize dividend-paying shares more or less together, and
pay less attention to whether the yield on a particular share is three or four percent.
But perhaps the most crucial difference is that catering takes a less extreme view on how
fast managers or arbitrageurs eliminate an emerging dividend premium or discount. According to
Black and Scholes, managers compete so aggressively that a nontrivial dividend premium or
discount never arises, and so for a given firm dividend policy remains effectively irrelevant. This
argument is compelling only if fluctuations in the demand for dividends are small relative to the
capacity of firms to adjust supply. It is not obvious a priori that this is the case, particularly if
demand is affected by sentiment. The catering theory acknowledges the possibility of a nontrivial
dividend premium, and thus the relevance of dividend policy.
The main prediction of the catering theory is that the propensity to pay dividends depends
on a measurable dividend premium in stock prices. To test this hypothesis, we construct four
time series measures of the demand for dividend-paying shares. The broadest one is what we
simply call the dividend premium – it is the difference between the average market-to-book ratio
of dividend payers and nonpayers. The other measures are the difference in the prices of Citizens
Utilities’ cash dividend and stock dividend share classes (between 1956 and 1989 CU had two
classes of shares which differed in the form but not the level of their payouts); the average
announcement effect of recent dividend initiations; and the difference between the future stock
returns of payers and nonpayers. Intuition suggests that the dividend premium, the CU dividend
premium, and initiation effects would be positively related to investor demand for dividends. In
contrast, the difference in future returns of payers and nonpayers would be negatively related to
any such demand – if demand for payers is so high that they are relatively overpriced, their
future returns will be relatively low.
We then use these four measures of demand to explain time variation in aggregate rate of
dividend initiation and omission. The results on initiations are the strongest. Each of the four
demand measures is a significant predictor of the rate of initiation. The lagged dividend premium
variable by itself explains a remarkable sixty percent of the annual variation in the initiation rate.
Another perspective is future stock returns. When the initiation rate increases by one standard
deviation, returns on payers are lower than nonpayers by nine percentage points per year over the
next three years. Conversely, the omission rate increases when the dividend premium is low, and
when future returns on payers are high.
After considering several alternative explanations, we conclude that the results are best
explained by catering. Explanations based on time-varying firm characteristics such as
investment opportunities or profitability, for example, do not account for the results: The
dividend premium variable helps to explain the residual “propensity to initiate” dividends that
remains after controlling for changing firm characteristics, including investment opportunities,
profits, and firm size using the methodology of Fama and French (2001). Alternative
explanations based on time-varying contracting problems, such as agency or asymmetric
information theories, do not address many aspects of the results, for instance why dividend
policy would related to the CU dividend premium and future returns. The lack of a compelling