Earnings per share versus cash flow per share as predictor of dividends per share

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  • Managerial FinanceEarnings per share versus cash flow per share as predictor of dividends per shareJohn Consler Greg M. Lepak Susan F. Havranek

    Article information:To cite this document:John Consler Greg M. Lepak Susan F. Havranek, (2011),"Earnings per share versus cash flow per share aspredictor of dividends per share", Managerial Finance, Vol. 37 Iss 5 pp. 482 - 488Permanent link to this document:http://dx.doi.org/10.1108/03074351111126960

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    http://dx.doi.org/10.1108/03074351111126960

  • Earnings per share versuscash flow per share as predictor

    of dividends per shareJohn Consler and Greg M. LepakDepartment of Business Administration,

    Le Moyne College, Syracuse, New York, USA, and

    Susan F. HavranekDepartment of Accounting, Le Moyne College, Syracuse, New York, USA

    Abstract

    Purpose The purpose of this paper is to compare the relative power of operating cash flow andearnings in the prediction of dividends.

    Design/methodology/approach A linear mixed effects model is used in terms of selected modelfit criteria.

    Findings Based on the selected model fit criteria, cash flow per share is shown to produce a betterfit than earnings per share, but it cannot be said how much better.

    Research limitations/implications Quarterly CRSP and Compustat data from 2000 to 2006 for1,902 dividend-paying firms are analyzed. Future work would need a different methodology todetermine how much better cash flow is as a predictor of dividends.

    Practical implications Both earnings per share and cash flow per share are found to bereasonable dividend predictors.

    Social implications Additional insight is provided on modeling factors that contribute to a firmsdecision to engage or disengage in a dividend payment policy.

    Originality/value The study described in this paper continues work on predicting dividendsper share. Results show cash flow per share is a better predictor than earnings per share. Investors andanalysts predict dividends as part of their stock valuation work. This study suggests focusingattention on using cash flow per share as the predictor of dividends.

    Keywords Dividends, Cash flow, Earnings per share, Modelling

    Paper type Research paper

    I. IntroductionCash flow might be expected to be a better predictor of dividends than earnings,because cash flow is less subject to accounting manipulation than earnings. It can beargued, cash flow is necessary for earnings, which are necessary for cash dividends.While the link between earnings and dividends has been well established in theliterature, little work has been done linking cash flow directly to dividends. This studyinvestigates this issue to see if cash flow is the better predictor of dividends.

    Quarterly CRSP and Compustat data from 1,902 dividend-paying firms between 2000and 2006 are used in the study. Linear mixed effects models are used to test whichvariable, earnings per share or cash flow per share, is the better predictor of dividendsper share. Models are tested both without and with control variables of total assets, debtratio, market to book value ratio, current liquidity ratio, quarterly beta, and fourthquarter indicator. These control variables have been shown to have significantrelationships to dividends in prior studies.

    The current issue and full text archive of this journal is available at

    www.emeraldinsight.com/0307-4358.htm

    MF37,5

    482

    Managerial FinanceVol. 37 No. 5, 2011pp. 482-488q Emerald Group Publishing Limited0307-4358DOI 10.1108/03074351111126960

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  • Cash flow per share is shown to be the better predictor of dividends per share, bothwithout and with control variables, in terms of selected model fit criteria. However, giventhe model used, it is not clear if cash flow is a significantly better predictor.

    II. Literature reviewArticles since 1985 provided the relevant literature review. Miller and Rock (1985) findearnings determine firm value with asymmetric information. This would argue thatearnings per share might be a good predictor of dividends per share with minimal timelags. This provides a base upon which to build the literature review.

    Cambell and Shiller (1988) establish a link between the moving average of a firmsearnings and the present value of all future dividends. This predictive ability may holdtrue for earnings per share and dividends per share, as well.

    McCann and Olson (1994) provide further support for the relationship between afirms earnings and dividends. The article supports the paying of dividends regardlessof the perfection of the capital markets.

    Benartzi et al. (1997) find that dividends convey information on current and pastearnings. Therefore, the reverse may be true also. Support for concurrent changes inearnings and dividends is provided. This again argues for minimal time lags in currentwork.

    Lamont (1998) uses quarterly earnings to help predict short-term returnssuccessfully. This work supports the minimal time lag concept.

    Fama and French (2001) support profitability as one characteristic that affects afirms decision to pay cash dividends. Strongly negative earnings cause termination ofcash dividend payments. This work suggests a relationship between earnings and cashdividends.

    Koch and Sun (2004) find that the market reaction to dividend changes is a delayedreaction to previous changes in earnings. Support for a relationship between earningsand dividends is implied.

    Liu et al. (2007) investigate if operating cash flows or accounting earnings are betterat explaining equity valuations. In all cases, earnings forecasts were a better summarymeasure of value. This article was critical in stimulating the current work. The questionof earnings versus cash flow can be applied to predicting dividends, as well as valuation.

    Recent work provides further support for the link between earnings and dividends.Bali et al. (2008) find a strong positive relationship between earnings and expectedreturns, which includes dividends.

    The constant dividend growth model for valuing stocks suggests that value investorsare attracted and retained when firms are able to evidence a long history of stabledividend payments. However, Fama and French (2001) document that fewer firms arepaying dividends and that strongly negative earnings cause termination of cashdividend payments. While most of the literature supports a strong relationship betweenearnings and dividends, this study will investigate if the relationship between cash flowand dividends is even stronger.

    III. Sample and dataFirms that declared cash dividends, excluding payments made as part of liquidations,acquisitions or reorganizations, during the period of January 1, 2000 and March 31, 2006were identified in CRSP. It was assumed that dividends declarations made during

    Predictorof dividends

    per share

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  • the last 15 days of a quarter and anytime during the following quarter prior to the last15 days were dependent on the quarter of interest. For example, if the first quarter runsJanuary 1-March 31, dividends declared between March 16 and June 15 would beassumed to be dependent on financial activity during the first quarter.

    Some industries were observed to have monthly dividend payments or multiple typesof cash dividends as coded by CRSP. When this was the case, the mu