What is 'Dividend Signaling'?

Dividend signaling is a theory that suggests that when 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 by proponents of inefficient markets.

BREAKING DOWN '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 positive future performance of the company's stock while, conversely, decreases in dividend payouts tend to accurately portend negative future performance by the company.

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.

Dividend Signaling in the Real World

A company with a lengthy history of dividend increases each year is signaling to the market that its management and board anticipate future profits. Dividends are typically not increased unless the board is certain the cost can be sustained. There are several stocks with histories that seem promising for investors seeking ever-increasing dividends, for example, National Fuel Gas, the FedEx Corporation and the Franco-Nevada Corporation.

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