The role of earnings information in corporate dividend decisions

This paper examines the role of earnings information in the determination of dividend policy. We decompose accounting earnings into permanent and transitory components and postulate that dividend policy is driven by sustainable permanent earnings. Two measures of permanent earnings are proposed. The first is a permanent earnings variable extracted from accounting earnings by a random-level shift ARMA model. The second measure is stock price times cost of capital. These two permanent earnings measures are employed in the Marsh-Merton (1987) model to explain corporate dividend behavior and their performance is compared. A generalized friction method is adopted for empirical estimation to account for stepwise dividend movements over time. Results show that the permanent earnings measure extracted from accounting earnings data explains dividend dynamic behavior better than stock price.