Disappearing dividends: Catering managers or increased growth opportunities

Abstract

I study the catering theory of dividends (Baker and Wurgler, 2004) and shed further light to the question: are managers catering to the demand for dividends or are companies' real growth expectations a more important driver for dividend policy. Baker and Wurgler (2004) assume inefficient stock markets and argue that corporate managers are increasing the short-term value of their companies by changing the dividend payout policy according to the investor demand for dividends i.e. catering to the dividend demand.

The main challenge in interpreting the results of Baker and Wurgler (2004a) is that they use the average market-to-book ratio of dividend payers relative to the average market-to-book ratio of nonpayers as a proxy for dividend demand. They, thus, assume that the market-to-book ratio measures the mispricing of a company - not its growth prospects. I employ an improved proxy for the demand for dividends by decomposing the market-to-book ratio to a mispricing component and a growth opportunity component. In a novel approach, I apply the decomposition of market-to-book ratio method (Rhodes-Kropf, Robinson and Viswanathan, 2005) to dividend policy decisions as a means of gaining more credible results. The decomposition method has previously been employed when studying other corporate decisions, e.g. merger activity and timing of seasoned equity offerings, but not dividend policy decisions. By decomposing the market-to-book ratio, I am able to analyse the dividend decisions from both the perceived market mispricing and individual company growth opportunity point of views. By using the traditional market-to-book ratio, as Baker and Wurgler (2004a) have done, these separate motives are mixed.

My data set consists of firm-years in the US market (NYSE, AMEX and Nasdaq) during the period of 1981-2008.

I find no support for the catering theory of dividends. Instead, the growth opportunities of companies seem to play a more important role in dividend initiation decisions. In dividend omission decisions, it seems that neither the growth opportunities nor the catering motives explain the decisions. My findings are consistent with the trade-off/life-cycle theory of dividends.