Dividend Signaling

What Is Dividend Signaling?

Dividend signaling is a theory that recommends that a company's announcement of an increase in dividend payouts is an indication of positive future possibilities.

The theory is tied to concepts in game theory: Managers with positive investment potential are bound to signal, while those without such possibilities refrain. Albeit the concept of dividend signaling has been widely challenged, the theory is as yet utilized by certain investors.

Understanding Dividend Signaling

Since the dividend signaling theory has been dealt with warily by analysts and investors, it has been standard tried. On the whole, studies show that dividend signaling happens. Increases in a company's dividend payout generally forecast a positive future performance of the company's stock. Alternately, diminishes in dividend payouts tend to portend negative future performance by the company precisely.

Numerous investors monitor a company's cash flow, meaning how much cash the company creates from operations. Assuming the company is profitable, it ought to produce positive cash flow, and have an adequate number of funds set to the side in retained earnings to pay out or increase dividends. Retained earnings is similar to a savings account that gathers excess profits to be paid out to shareholders or invested once more into the business. Nonetheless, a company that has a lot of cash on its balance sheet can in any case experience quarters with low earnings growth or losses. The cash on the balance sheet could in any case allow the company to increase its dividend notwithstanding troublesome times on the grounds that the business accumulated sufficient cash throughout the long term.

On the off chance that dividend signaling happens with a company, the earnings could increase, yet on the off chance that incidentally, the company had accounting errors, a scandal, or a product recall, earnings could endure suddenly. In this way, dividend signaling could show higher earnings in store for a company as well as a higher stock price. In any case, it doesn't be guaranteed to mean that a negative event couldn't happen before or after the earnings release.

Testing the Dividend Signaling Theory

Two teachers at the Massachusetts Institute of Technology (MIT), James Poterba and Lawrence Summers, composed a series of papers from 1983 to 1985 that recorded signaling theory testing. In the wake of getting 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 Summers developed a "customary view" of dividends that incorporates the hypotheses that dividends signal some private data about profitability.

As per the theory, stock prices tend to rise when a company declares an increase in dividend payouts and fall when dividends are to be diminished. The scientists presumed that there is no way to see a difference between the hypothesis that an increased dividend conveys uplifting news and the hypothesis that the dividend increase is uplifting news for investors.

Profitability

The dividend signaling theory recommends that companies paying the highest level of dividends are, or ought to be, more profitable than in any case indistinguishable companies paying more modest dividends. This concept shows that the signaling theory can be questioned assuming an investor looks at how widely current dividends act as indicators of future earnings.

Prior studies, led from 1973 to 1978, inferred that a firm's dividends are fundamentally unrelated to the earnings that follow. In any case, a study in 1987 presumed that analysts regularly right earnings forecasts as a response to startling changes in dividend payouts, and these revisions are a rational response.

Real World Examples of Dividend Signaling

A company with an extended history of dividend increases every year may be signaling to the market that its management and board of directors expect future profits. Dividends are regularly not increased except if the board is certain the cost can be supported.

Coca-Cola Corporation (KO)

Coca-Cola Corporation (KO) has been expanding its dividend for north of 50 years and started paying dividends in 1920. Be that as it may, notwithstanding the reliable increase in dividends, KO's revenue has declined in recent years as sweet soft drinks have fallen undesirable with consumers. In Q1 of 2016, KO created $10 billion in revenue while in Q1 of 2019, the company produced $8 billion in revenue — a 20% decline. Annual profit or net income was $6.5 billion out of 2016 and roughly $6.4 billion out of 2018.

Albeit the company was profitable every year, profits and revenue didn't increase consistently regardless of higher dividends. Notwithstanding, from the chart below, we can see that the stock price rose from almost $41 in 2016 to $50 in 2018.

Every year dividends increased, illustrated at the lower part of the chart, which upholds the theory that rising dividends can be indicative of a higher future stock price.

Of course, companies like Coca-Cola can likewise work on the stock's performance by cutting costs and buying back shares. By and by, the consistency of a dividend payer can be a strong magnet, pulling investors to a stock regardless of whether the company increases profits every year.

Lowes Companies Inc. (LOW)

Lowes Inc. (LOW) has increased its dividend for north of 50 years and has paid one every year starting around 1961. The company's revenue has consistently risen starting around 2016 from $56 billion to roughly $70 billion by Q1 2019. Annual profit or net income rose from $2.7 billion of every 2016 to $3.4 billion out of 2018.

From the chart below, we can see that the stock price rose from almost $70 in 2016 to as high as $117 in 2018 before remembering back to ~$97.50 by year-end. Likewise, dividends rose from 28 pennies in 2016 to 48 pennies in 2018. Defenders of dividend signaling could point to Lowes to act as an illustration of executive management signaling that higher dividends ought to correspond to a higher stock price.

Special Considerations

In our models above, we're just examining a couple of years' worth of data for two stocks. Numerous different factors likewise drive a stock price higher or lower other than dividends, including economic conditions, consumer spending, management effectiveness, sales, and earnings. Several different stocks with strong dividend-paying chronicles seem promising for investors seeking steadily expanding dividends, including National Fuel Gas Company, the FedEx Corporation, and the Franco-Nevada Corporation.

Highlights

• Expanding a company's dividend payout may foresee positive performance of the company's stock from now on.
• Dividend signaling posits that dividend increases are an indication of positive future outcomes for a firm, and that main managers regulating positive potential will give such a signal.
• The dividend signaling theory recommends that companies that pay the highest dividends are, or ought to be, more profitable than those paying more modest dividends.