The Surprising Link Between Dividends & Earnings

How can you really trust that a company’s public statements are accurate?

The 2002 Sarbanes-Oxley Act was supposed to make accounting statements more transparent in the wake of the Enron scandal.

There are many who feel that Sarbanes-Oxley has only made financial statements more confusing.

How are we supposed to know whether or not the profits reported on accounting statements are real, tangible earnings, or an accounting fiction?

It is virtually impossible for the individual investor to go and visit the corporate headquarters of all of their stock holdings and have a chat with the CEO of major corporations. Even if you could, a dishonest CEO wouldn’t openly come forward with any discrepancies.

Is there a way to confirm the earnings on the income statement and the cash flows on the cash flow statement?

Dividends Are the Answer

The answer is that dividend paying companies must be making money, or they wouldn’t be able to pay out dividends for very long.

If a company can pay out dividends, it must be generating positive cash flows. If it isn’t, it will soon be forced to cut its dividend payments.

Dividends show earnings are real. Dividend growth shows real earnings growth. That’s why Dividend Aristocrats tend to do so well over time.

Dividends Increases Confirm Earnings Growth

The only way a management team can consistently raise its dividend payments is if earnings are truly rising year-after-year.

If growth is not persistent, then management would not be able to continue raising dividends.

A 2004 study by Koch and Sun examines whether the market interprets changes in dividends as a signal about the persistence of past earnings growth.  Here’s what they found:

“Results confirm the hypothesis that changes in dividends cause investors to revise their expectations about the persistence of past earnings changes.  The effect varies predictably with the magnitude of the dividend change and the sign of the past earnings change.”