Increasing dividends and stock buybacks tends to lower cash-flow volatility, according to a new study
For years markets looked at dividends as signals the company was in good shape and higher profits were in store. Unfortunately, analysis of the data never confirmed that connection. But as a predictor of cash-flow volatility, dividends can be very useful, according to a recent study from the National Bureau of Economic Research (NBER).
Specifically, the study suggests that cash-flow volatility “should decrease following a dividend increase and should increase following a dividend decrease,” according to Roni Michaely of Cornell’s Johnson Graduate School of Management, Michael Weber of the University of Chicago’s Booth School of Business and Stefano Rossi, a professor of finance at Bocconi University in Milan. “Furthermore, larger dividend payments should carry more information; specifically, both larger decreases in cash-flow volatility and larger cumulative abnormal returns should be observed around the announcement of larger dividend increases.”
Why? The study suggests that market reaction to a dividend announcement has significant impact. That is, dividends “signal safer, rather than higher, future profits” and thus, lower volatility.
“We find the variance of cash-flow news is significantly lower after dividend increases and initiations, and the variance of cash-flow news is significantly higher after dividend decreases and omissions,” the authors write. “Consistent with our theory, larger changes in dividends are associated with larger changes in cash-flow volatility in the expected direction, and announcements of larger changes in dividends are associated with larger cumulative abnormal returns in the same direction.”
The study, entitled, “The Information Content of Dividends: Safer Profits, Not Higher Profits,” says that the idea of dividends predicting future profits dates as far back as a (Merton) Miller and (Franco) Modigliani study from 1961, which speculated that dividend changes convey information about firms’ future prospects. Other studies “later formalize this idea, suggesting dividends signal future profits. This idea thought that dividend changes “should be followed by earnings or cash-flow changes in the same direction. “However, numerous empirical studies have failed to find evidence supporting this mechanism,” the new study says.
In fact the new study concludes that there are many opposite outcomes compared to previous studies. For instance, the study points out, existing models predict that younger and riskier firms “should be more likely to signal with dividend payouts than mature firms, because they have more incentives to do so. Yet empirical evidence suggests exactly the opposite: mature and less risky firms pay the bulk of dividends.”
The study also says that share buybacks can offer similar guidance on volatility. This means, the larger the share repurchase, the lower the volatility. Since share repurchases are “just another way to return cash to shareholders,” the authors argue, “we expect a pattern of changes in cash-flow volatility following share-repurchase announcements similar to that following announcements of dividend increases and initiations.” As a result, they found a “strong decline in cash-flow volatility following share-repurchase announcements” and also consistent with their hypothesis, “we find larger share-repurchase programs associated with both larger reductions in cash-flow volatility and larger announcement returns.”
Treasuries are always contending with volatility in cash flows and the balance sheet, primarily using hedge strategies to reduce it. Perhaps a look at the company’s payout policy, i.e., dividends and share repurchases, can help better control volatility.