Question

Agree with the dividend signaling hypothesis, that managers who know more inside info on future corporate growth convey that information to external investors through dividend payouts? Does the signaling hypothesis suggest that there is a positive relationship between the info asymmetry and dividend payouts?

Answer 1

What Is Dividend Signaling?

Dividend signaling is a theory that suggests that a company announcement of an increase in dividend payouts is an indication of positive future prospects. The theory is directly tied to game theory; managers with good investment potential are more likely to signal. While the concept of dividend signaling has been widely contested, the theory is still a concept used today by some investors.

Understanding Dividend Signaling

Because the dividend signaling theory has been treated skeptically by analysts and investors, there has been regular testing of the theory. On the whole, studies indicate that dividend signaling does occur. Increases in a company's dividend payout generally forecast a positive future performance of the company's stock. Conversely, decreases in dividend payouts tend to accurately portend negative future performance by the company.

Many investors monitor a company's cash flow, meaning how much cash the company generates from operations. If the company is profitable, it should generate positive cash flow, and have enough funds set aside in retained earnings to pay out or increase dividends. Retained earnings is akin to a savings account that accumulates excess profits to be paid out to shareholders or invested back into the business. However, a company that has a significant amount of cash on its balance sheet can still experience quarters with low earnings growth or losses. The cash on the balance sheet might still allow the company to increase its dividend despite difficult times because they accumulated enough cash over the years.

If dividend signaling occurs with a company, the earnings could increase, but if it turns out that the company had accounting errors, a scandal, or a product recall, earnings could suffer unexpectedly. As a result, dividend signaling might indicate higher earnings in the future for a company as well as a higher stock price. However, it doesn't necessarily mean that a negative event couldn't occur before or after the earnings release.

Testing the Theory

Two professors at the Massachusetts Institute of Technology (MIT), James Poterba and Lawrence Summers, wrote a series of papers from 1983 to 1985 that documented testing of the signaling theory. After obtaining empirical data on the relative market value of dividends and capital gains, the effect of dividend taxation on dividend payout and the impact of dividend taxation on investment, Poterba and Lawrence developed a "traditional view" of dividends that includes the theories that dividends signal some private information about profitability.

According to the theory, stock prices tend to rise when a company announces an increase in dividend payouts and fall when dividends are to be decreased. The researchers concluded that there is no discernible difference between the hypothesis that an increased dividend conveys good news and the hypothesis that the dividend increase is good news for investors.

Profitability

The dividend signaling theory suggests that companies paying the highest level of dividends are, or should be, more profitable than otherwise identical companies paying smaller dividends. This concept indicates that the signaling theory can be disputed if an investor examines how extensively current dividends act as predictors of future earnings.

Earlier studies, conducted from 1973 to 1978, concluded that a firm’s dividends are basically unrelated to the earnings that follow. However, a study in 1987 concluded that analysts typically correct earnings forecasts as a response to unexpected changes in dividend payouts, and these corrections are a rational response.