A Catering Theory of Dividends Malcolm Baker Harvard Business School and NBER mbaker hbs edu Jeffrey Wurgler NYU Stern School of Business jwurgler stern nyu edu November 7 2002 Abstract We develop a theory in which the decision to pay dividends is driven by investor demand Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers To test this prediction we construct four time series measures of the investor demand for dividend payers By each measure nonpayers initiate dividends when demand for payers is high By some measures payers omit dividends when demand is low Further analysis confirms that the results are better explained by the catering theory than other theories of dividends We would like to thank Viral Acharya Raj Aggarwal Katharine Baker Randy Cohen Gene D Avolio Steve Figlewski Xavier Gabaix Paul Gompers Florian Heider Dirk Jenter Kose John Steve Kaplan John Long Asis Martinez Jerez Colin Mayer Holger Mueller Eli Ofek Lubos Pastor Lasse Pedersen Gordon Phillips Raghu Rau Jay Ritter Rick Ruback David Scharfstein Hersh Shefrin Andrei Shleifer Erik Stafford Jeremy Stein Ryan Taliaferro Jerold Warner Luigi Zingales and seminar participants at Dartmouth Harvard Business School London Business School LSE MIT NYU Oxford the University of Chicago the University of Michigan the University of Rochester and Washington University for helpful comments John Long and Simon Wheatley for data and Ryan Taliaferro for superb research assistance Baker gratefully acknowledges financial support from the Division of Research of the Harvard Business School A Catering Theory of Dividends Abstract We develop a theory in which the decision to pay dividends is driven by investor demand Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers To test this prediction we construct four time series measures of the investor demand for dividend payers By each measure nonpayers initiate dividends when demand for payers is high By some measures payers omit dividends when demand is low Further analysis confirms that the results are better explained by the catering theory than other theories of dividends I Introduction Miller and Modigiliani 1961 prove that dividend policy is irrelevant to stock price in perfect and efficient capital markets In that setup no rational investor has a preference between dividends and capital gains Arbitrage ensures that dividend policy is irrelevant Over forty years later the only assumption in this proof that has not been thoroughly scrutinized is market efficiency 1 In this paper we present a theory of dividends that relaxes this assumption It has three basic ingredients First for either psychological or institutional reasons some investors have an uninformed time varying demand for dividend paying stocks Second arbitrage fails to prevent this demand from driving apart the prices of stocks that do and do not pay dividends Third managers cater to investor demand paying dividends when investors put a higher price on the shares of payers and not paying when investors prefer nonpayers We formalize this catering theory of dividends in a simple model The catering theory differs from the standard view of the effect of investor demand on dividend policy The standard view emphasizes the irrelevance of dividend policy to share prices even when some investor clienteles have a rational preference for dividends For example Black and Scholes 1974 write If a corporation could increase its share price by increasing or decreasing its payout ratio then many corporations would do so which would saturate the demand for higher or lower dividend yields and would bring about an equilibrium in which marginal changes in a corporation s dividend policy would have no effect on the price of its stock p 2 This equilibrium intuition for dividend irrelevance can also be found in corporate finance textbooks 1 Allen and Michaely 2002 provide a comprehensive survey of payout policy research 1 The catering theory and the clientele equilibrium theory differ on several key points One is that catering takes seriously the possibility that investor demand for dividends is affected by sentiment This adds a new and unexplored source of demand to the rational dividend clienteles considered by Black and Scholes Another difference is that the catering view focuses more on the demand for shares that pay dividends whereas the determinate supply response in a clientele equilibrium view is the overall level of dividends For example we discuss the possibility that managers cater to investors who categorize dividend paying shares more or less together and pay less attention to whether the yield on a particular share is three or four percent But perhaps the most crucial difference is that catering takes a less extreme view on how fast managers or arbitrageurs eliminate an emerging dividend premium or discount According to Black and Scholes managers compete so aggressively that a nontrivial dividend premium or discount never arises and so for a given firm dividend policy remains effectively irrelevant This argument is compelling only if fluctuations in the demand for dividends are small relative to the capacity of firms to adjust supply It is not obvious a priori that this is the case particularly if demand is affected by sentiment The catering theory acknowledges the possibility of a nontrivial dividend premium and thus the relevance of dividend policy The main prediction of the catering theory is that the propensity to pay dividends depends on a measurable dividend premium in stock prices To test this hypothesis we construct four time series measures of the demand for dividend paying shares The broadest one is what we simply call the dividend premium it is the difference between the average market to book ratio of dividend payers and nonpayers The other measures are the difference in the prices of Citizens Utilities cash dividend and stock dividend share classes between 1956 and 1989 CU had two classes of shares which differed in the form but not the level of their payouts the average 2 announcement effect of recent dividend initiations and the difference between the future stock returns of payers and nonpayers Intuition suggests that the dividend premium the CU dividend premium and initiation effects would be positively related to investor demand