Publicly traded firms typically distribute cash to stockholders
as dividends or stock repurchases. Dividends
are cash distributions to stockholders, while repurchases
involve companies buying back their shares from stockholders.
Previous research by Eugene F. Fama, Robert R. McCormick
Distinguished Service Professor of Finance at the University
of Chicago Graduate School of Business, and Kenneth French
of Dartmouth University’s Tuck School of Business shows that
far fewer U.S. companies are paying dividends to their stockholders
today than in the late 1970s. Repurchases emerged as
an economically significant phenomenon in the early 1980s,
and by 1998, the amount of stock repurchases exceeded the
amount of dividends.
A new study, “The Evolving Relation between Earnings,
Dividends, and Stock Repurchases” by University of Chicago
Graduate School of Business professor Douglas J. Skinner,
suggests that companies now view dividends and stock
repurchases as essentially equivalent methods of paying out
earnings to stockholders and analyzes whether the change
in payout policy is linked to changes in reported earnings.
“I wanted to investigate whether the increase in the
variability of earnings made it more difficult for companies
to pay dividends, since dividends are usually paid based
on earnings.” explains Skinner.
Over the last 20 to 30 years, the nature of corporate earnings
has changed, with greater variation across firms: losses are
much more common; earnings are increasingly concentrated
in a small group of very large firms; and earnings tend to be
more volatile over time for a given firm.
Skinner shows that the increased volatility of earnings
helps explain changes in payout policy over the last 30 years.
First, Skinner shows that since 1980 there have been three
main groups of payers: 1) established firms that have always
paid dividends and now also make repurchases on a regular
basis; 2) firms that make regular repurchases but do not pay
dividends; and 3) firms that make occasional repurchases.
Skinner finds that firms in the first group have been paying
dividends for decades and continue to do so�largely because
of their dividend history. Over time, managers of these firms
increasingly use repurchases to pay out earnings increases, with
dividend policy becoming more conservative. This suggests the
reluctance to reduce or omit dividends has become stronger
in recent years. Skinner also finds that these firms dominate
the set of publicly held firms, accounting for more than half
of all total earnings and payouts.
These results suggest repurchases are increasingly used in
place of regular dividends. The result holds not only for those
large, mature, and profitable firms that continue to pay dividends,
but also for firms that only make repurchases, most
of which have never paid dividends.
Dividends vs. Stock Repurchases
“Financial economists have always been puzzled that companies
pay dividends at all, given their tax disadvantaged status relative
to stock repurchases,” says Skinner.
Furthermore, dividends represent a significant ongoing
commitment by the firm. Once companies have established
a dividend, they only reduce or omit them in exceptional circumstances,
because dividend reductions are interpreted by
the market as a negative signal about the company’s future
earnings prospects. This explains managers’ tendency to
increase dividends conservatively, and why firms that do not
already pay dividends prefer to make repurchases rather than
initiating a dividend. For example, Oracle and Dell have never
paid dividends, but make substantial repurchases.
“Dividend policies are incredibly sticky�once firms have
established a dividend amount, they feel as if they have to
maintain that level of dividends going forward,” notes Skinner.
One problem with increasingly variable earnings is it
becomes difficult for companies to be sure they can maintain
their level of dividend payments.
“There’s total flexibility with stock repurchases, whereas
you’re committed forever with a dividend,” says Skinner. “With
repurchases, you could pay out $3 billion in total repurchases
one period and zero the next.”
The availability of repurchases means that newer firms
without a dividend history are unlikely to initiate a dividend.
For the majority of firms, dividends do not offer benefits over
repurchases. Although some argue that dividends are useful
barometers of “earnings quality,” there is not much evidence
to support this idea.
The Stubstitution Hypothesis
“The main contribution of this study is the substitution
hypothesis�determining if stock repurchases are actually
used as substitutes for dividends,” says Skinner. “If this is the
case, stock repurchases should be linked to earnings, because
prior research has shown that managers set dividends based
on current and past earnings.”
Skinner finds that the relationship between dividends and
earnings has become weaker in recent decades, largely because
managers now set dividends in a mechanical fashion�with
small, predictable increases. At the same time, the relation
between earnings and repurchases has become stronger, suggesting
that managers are increasingly using repurchases to
pay out earnings increases.
To test the substitution hypothesis, Skinner used a panel of
data on earnings, dividends, and net repurchases for publicly
held U.S. industrial firms from 1980
to 2005. Skinner finds that earnings
become increasingly volatile over
time, partly due to the increasing
frequency and magnitude of losses,
which helps explain the growth of
repurchases as a substitute for dividends; for legal and institutional
reasons, it is often difficult to pay dividends when
the firm reports losses.
Due to a change in regulation, stock repurchases emerged
as a viable form of payout around 1983 and increased rapidly
after that time. Aggregate net repurchases were consistently
in the $30 billion range from 1985 to 1990 before declining
briefly in the early 1990s. After this, repurchases increased
dramatically, and exceeded aggregate dividends for the first
time in 1998. Net repurchases also exceeded dividends in
1999, 2000, 2004, and 2005. Aggregate repurchases grew
to $233 billion in 2004, nearly twice the level in 1998. This
amount is substantially larger than dividends, which totaled
$197 billion in 2004.
Consistent with the previous research by Fama and French,
Skinner finds that the proportion of dividend payers, which
peaked in the late 1970s at around 66 percent, declined steadily
over this period, from 42 percent in 1980�89 to 28 percent in
1995�2004. In spite of the decline in the number of dividend-paying
firms, aggregate dividends increase over this period,
reflecting a massive increase in the concentration of dividend
payments in a relatively small group of large, established firms.
Skinner finds that those firms that both pay dividends
and make repurchases have a conservative dividend policy
and use repurchases to supplement dividends in years with
strong earnings.
“If a firm has unusually high earnings one year, they’re not
going to increase dividends; instead, they’ll make a large stock
repurchase,” says Skinner.
Skinner predicts that firms that continue to pay dividends
do so largely because of history. To test this prediction, Skinner
measured the dividend history for these companies as the
number of years before 1980 in which they paid dividends.
Consistent with the idea that these firms only continue to pay
dividends because of their history, Skinner finds the following:
most firms that continue to pay dividends today have paid
dividends for many decades; firms that make regular repurchases
but do not pay dividends have little or no dividend
history; and few newer companies initiate dividends.
For firms that have never paid dividends but make regular
repurchases, Skinner also finds an increasingly strong relation
between earnings and repurchases, suggesting these firms use
repurchases in place of dividends.
Interestingly, Skinner finds that earnings also do a good
job of explaining payouts for firms that only make occasional
repurchases, consistent with the substitution hypothesis.
Other factors also explain repurchases. Previous research
finds that managers repurchase more when their companies’
stock prices are low�to offset the dilutive effects of stock
options programs and increase reported earnings-per-share.
While Skinner finds that these factors continue to explain
repurchases, he also finds that they largely explain the timing
of repurchases; the level of repurchases is driven by earnings.
Apart from those firms that continue to pay dividends and
make regular repurchases, dividend payers are no longer
economically important. From 1980 to 2005, the percentage
of firms that pay dividends but do not make repurchases
declined to 7 percent from 13 percent. Pure dividend-payers
are disappearing.
Dividends May Disappear
Dividends are now the domain of a relatively small group of
large well-established “blue chip” firms like GE, Exxon Mobil,
and Altria. Collectively, these companies now account for over
half of the dividends and earnings of all public firms listed in
the United States.
In addition, firms that only make repurchases have grown
considerably. This group will likely become more important
as relatively young technology firms continue to mature and
distribute more cash to stockholders.
“Some technology companies like Dell and Oracle have never
paid dividends, and my bet is they never will,” says Skinner.
“Companies that traditionally would have paid dividends are
going straight for stock repurchases.”
The results also suggest that industrial firms now display
a largely two-tiered structure, with a smaller number of large
firms that collectively dominate the distribution of both
earnings and payout, and a larger number of smaller, often
unprofitable firms with high growth opportunities. Some of
the top earners now eschew dividends in favor of repurchases,
which means that while the inertia in dividend payments
is considerable, there may come a time when dividends
completely disappear.
"The Evolving Relation between Earnings, Dividends, and Stock
Repurchases." Douglas J. Skinner. Forthcoming in the Journal
of Financial Economics.