A Catering Theory of Dividends∗Malcolm BakerHarvard Business School and [email protected] WurglerNYU Stern School of [email protected] 7, 2002AbstractWe 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 onpayers and not paying when investors prefer nonpayers. To test this prediction, we construct fourtime series measures of the investor demand for dividend payers. By each measure, nonpayersinitiate dividends when demand for payers is high. By some measures, payers omit dividendswhen demand is low. Further analysis confirms that the results are better explained by thecatering theory than other theories of dividends. ∗ We would like to thank Viral Acharya, Raj Aggarwal, Katharine Baker, Randy Cohen, Gene D'Avolio, SteveFiglewski, Xavier Gabaix, Paul Gompers, Florian Heider, Dirk Jenter, Kose John, Steve Kaplan, John Long, AsisMartinez-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, RyanTaliaferro, Jerold Warner, Luigi Zingales and seminar participants at Dartmouth, Harvard Business School, LondonBusiness School, LSE, MIT, NYU, Oxford, the University of Chicago, the University of Michigan, the University ofRochester, and Washington University for helpful comments; John Long and Simon Wheatley for data; and RyanTaliaferro for superb research assistance. Baker gratefully acknowledges financial support from the Division ofResearch of the Harvard Business School.A Catering Theory of DividendsAbstractWe 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 onpayers and not paying when investors prefer nonpayers. To test this prediction, we construct fourtime series measures of the investor demand for dividend payers. By each measure, nonpayersinitiate dividends when demand for payers is high. By some measures, payers omit dividendswhen demand is low. Further analysis confirms that the results are better explained by thecatering theory than other theories of dividends.1I. IntroductionMiller and Modigiliani (1961) prove that dividend policy is irrelevant to stock price inperfect and efficient capital markets. In that setup, no rational investor has a preference betweendividends and capital gains. Arbitrage ensures that dividend policy is irrelevant.Over forty years later, the only assumption in this proof that has not been thoroughlyscrutinized is market efficiency.1 In this paper, we present a theory of dividends that relaxes thisassumption. 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 notpay dividends. Third, managers cater to investor demand – paying dividends when investors puta higher price on the shares of payers, and not paying when investors prefer nonpayers. Weformalize this catering theory of dividends in a simple model.The catering theory differs from the standard view of the effect of investor demand ondividend policy. The standard view emphasizes the irrelevance of dividend policy to share priceseven when some investor clienteles have a rational preference for dividends. For example, Blackand Scholes (1974) write: “If a corporation could increase its share price by increasing (ordecreasing) its payout ratio, then many corporations would do so, which would saturate thedemand for higher (or lower) dividend yields, and would bring about an equilibrium in whichmarginal changes in a corporation’s dividend policy would have no effect on the price of itsstock” (p. 2). This equilibrium intuition for dividend irrelevance can also be found in corporatefinance textbooks. 1 Allen and Michaely (2002) provide a comprehensive survey of payout policy research.2The catering theory and the clientele equilibrium theory differ on several key points. Oneis that catering takes seriously the possibility that investor demand for dividends is affected bysentiment. This adds a new and unexplored source of demand to the rational dividend clientelesconsidered by Black and Scholes. Another difference is that the catering view focuses more onthe demand for shares that pay dividends, whereas the determinate supply response in a clienteleequilibrium view is the overall level of dividends. For example, we discuss the possibility thatmanagers cater to investors who categorize dividend-paying shares more or less together, andpay 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 howfast managers or arbitrageurs eliminate an emerging dividend premium or discount. According toBlack and Scholes, managers compete so aggressively that a nontrivial dividend premium ordiscount never arises, and so for a given firm dividend policy remains effectively irrelevant. Thisargument is compelling only if fluctuations in the demand for dividends are small relative to thecapacity of firms to adjust supply. It is not obvious a priori that this is the case, particularly ifdemand is affected by sentiment. The catering theory acknowledges the possibility of a nontrivialdividend premium, and thus the relevance of dividend policy.The main prediction of the catering theory is that the propensity to pay dividends dependson a measurable dividend premium in stock prices. To test this hypothesis, we construct fourtime series measures of the demand for dividend-paying shares. The broadest one is what wesimply call the dividend premium – it is the difference between the average market-to-book ratioof dividend payers and nonpayers. The other measures are the difference in the prices of CitizensUtilities’ cash dividend and stock dividend share classes (between 1956 and 1989 CU had twoclasses of shares which differed in the form but not the level of their payouts); the average3announcement effect of recent dividend initiations; and the difference between the future stockreturns of payers and nonpayers. Intuition suggests that the dividend premium, the CU