The Relationship between Dividend Payout and Price-to-Earnings

Abstract

Using a large database of S&P 1500 index firms spanning an 88-quarter period from 1995 through 2016, we document that market cap (firm size), book-to-market ratio (a proxy for market perception of inverse of growth potential) and industry matter for determining Price-to-Earnings (PE) levels as a function of payout levels: current-period dividend payout is significantly and positively correlated with next period PE ratio for high market cap firms, and significantly and negatively correlated for high book-to-market firms. However, once the PE levels are determined, current period dividend payout change is significantly and negatively associated with next period PE change. We show that an increase in current period payout signals reduced investment opportunities and increased risk, which reduce PE ratios.