The Payout Ratio, Earnings Growth and Returns: UK Industry Evidence.

This paper examines the role of the Payout Ratio as a predictor of future earnings growth and returns in UK industry data. We find, contrary to the suppositions of many practitioners, industries that have low payout ratios (relative to the industry time-series mean) have low subsequent earnings growth. This suggests that corporate managers are either over-investing or using dividends to ‘signal’ future earnings or simply that markets are competitive and excess profits within markets are rapidly competed away. Using a panel of 20 UK industries we provide evidence the relationship between the payout ratio and subsequent earnings growth remains positive throughout our sample period contrary to the perceived wisdom. At the five-year horizon the results are highly statistically significant and more than 30% of the variation in earnings growth can be captured by the payout ratio alone during any 10-year rolling window period. Novelly, we examine if dividing the dividend-price ratio into payout ratio and earnings-price ratio components enhances its ability to predict future returns. Panel evidence provides support that this leads to stronger return predictability for some sample periods. During these periods, it is found that returns tend to respond more strongly to the payout ratio than the earnings-price ratio consistent with favourable earnings growth predicted by payout ratio not being fully incorporated into current prices. Our main finding is that there is a robust, positive and statistically significant relationship between an industry’s payout ratio and its subsequent earnings growth, which is especially strong at the five-year horizon.