Common sense would dictate that, if a company pays out a high percentage of its earnings as dividends, then it has less money with which it can grow. Thus, high-dividend-payers should on average show lower earnings growth than companies that keep more money inside the company and reinvest it.

However, a study in the early 2000s by Robert Arnott and Clifford Asness (AIMR Magazine Jan/Feb. 2003) completely counters this viewpoint. In their study, the authors found that, “for companies, future earnings growth is fastest when payouts are high, and slowest when payouts are low. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth”.

Thus, if you pick the right companies, you can have high dividends and faster earnings growth. Sounds like investment nirvana to us. The authors go into all sorts of background, estimates and math to prove their point. We won’t repeat this, but here is the link to their study:

http://ow.ly/fOv0I

We will though, take a look at some of their conclusions, because they certainly make common sense, and might change the way you look at dividend payout ratios.

First, as you likely know, corporate managers absolutely hate to cut dividends. You know why—if you have seen the impact of dividend cuts: For example, Data Group Inc. (DGI on TSX) recently reduced its dividend in early November, and the stock fell 53% in four days.

So managers hate cutting their company’s dividend. If they see better times ahead for the company, they won’t. But if earnings are currently weak the current payout ratio will look high, even rising above 100%. Thus, the authors point out that a high dividend payout ratio now might actually indicate confidence in future earnings prospects. It even suggests this dividend confidence might be based on insider information, one of those rare circumstances where you might legally benefit from such info.

Another hypothesis on why high payout ratios equate to high earnings growth is a little bit more clear-cut. Simply, if companies have too much in retained earnings, then managers might tend to embark on ‘empire-building’ and engage in acquisitions and expansions that are not well thought-out. Think of your own finances. If you are tight on cash flow, what are the odds that you are going to drop $50,000 on that time-share condo in Arizona? Companies with less free cash (because of high dividends) thus need to carefully consider all spending plans that would eat up their available cash. They might not expand as rapidly, but they might expand more profitably.

A third hypothesis isn’t nearly as much fun. The authors indicate that the high correlation between payout ratios and earnings growth may not mean too much, and may be simple reversion to the mean. In other words, when earnings growth is low (high payout ratio) it is simply a bad year for the company or the economy, and high earnings growth will ultimately resume again to get back to the company’s average growth rate.

So what’s an investor to do? Well, we would first look at a company’s balance sheet. If a company has a high dividend payout ratio, you sure don’t want the dividend to be financed by debt. This is just asking for trouble. Second, look at a company’s historical earnings growth, and historical payout ratio. If it has a history of maintaining (or better yet, growing) dividends during tough times then a high payout ratio might not be a bad sign at all. Finally, we would use extreme caution in applying this study’s results to your own portfolio. Just because a company has a high payout ratio does not mean it is a great investment. It may be about to fall off a cliff, and an empirical, academic study is not going to help you pay your bills in retirement.