“Dividend Smoothing and Predictability” by Chen Long
Washington University in St. Louis
Norwegian School of Management
University of Notre Dame
The relative return/dividend predictability is a central issue since it forms the paradigm to interpret asset price variation. A little studied question is how dividend smoothing, as a choice of corporate policy, affects predictability. We show that, even if dividends are supposed to be predictable without smoothing, dividend smoothing can bury this predictability in a finite sample. We further show that aggregate dividends are dramatically more smoothed in the postwar period than before. Therefore, the lack of dividend growth predictability in the postwar period, as widely documented in the literature, does not necessarily mean that there is no cash flow news in stock price variations; rather, a more plausible interpretation is that dividends are smoothed. To confirm this point, we sort firms into portfolios based on how smooth their dividends are. We find that dividend growth is unpredictable for firms that have most smoothed their dividends, but predictable for firms that have least smoothed their dividends. In contrast, earnings growth is predictable for all portfolios. Our take-away messages are that (i) dividend smoothing can severely affect dividend predictability in a finite sample, (ii) there is significant cash flow news in stock price variations, and (iii) when smoothed, dividends do not represent well the outlook of future cash flows.