Question

1. Explain the process of dividend smoothing in the context of signaling.
2. Provide a few reasons firms engage in dividend smoothing. In other words, why do they bother? What is the benefit or what are they protecting against?

Answer 1

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.

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.

EXAMPLE

A company with a lengthy history of dividend increases each year might be signaling to the market that its management and board of directors anticipate future profits. Dividends are typically not increased unless the board is certain the cost can be sustained.

BENEFIT

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.