Dividend Signaling

What Is Dividend Signaling?

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

The theory is tied to concepts in game theory: Managers with positive investment potential are more likely to signal, while those without such prospects refrain. Although the concept of dividend signaling has been widely contested, the theory is still used by some investors.

Understanding Dividend Signaling

Because the dividend signaling theory has been treated skeptically by analysts and investors, it has been regular tested. 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 the business 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. So, 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 Dividend Signaling 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 signaling theory testing. 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 Summers 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.

Real World Examples of Dividend Signaling

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.

Coca-Cola Corporation (KO)

Coca-Cola Corporation (KO) has been increasing its dividend for over 50 years and began paying dividends in 1920. However, despite the consistent increase in dividends, KO's revenue has declined in recent years as sugary sodas have fallen out of favor with consumers. In Q1 of 2016, KO generated $10 billion in revenue while in Q1 of 2019, the company generated $8 billion in revenue — a 20% decline. Annual profit or net income was $6.5 billion in 2016 and approximately $6.4 billion in 2018.

Although the company was profitable each year, profits and revenue didn't increase every year despite higher dividends. However, from the chart below, we can see that the stock price rose from nearly $41 in 2016 to $50 in 2018.

Each year dividends increased, outlined at the bottom of the chart, which supports the theory that increasing dividends can be indicative of a higher future stock price.

Image by Sabrina Jiang © Investopedia 2021

Of course, companies like Coca-Cola can also improve the stock's performance by cutting costs and buying back shares. Nevertheless, the consistency of a dividend payer can be a powerful magnet, pulling investors to a stock whether the company increases profits each year or not.

Lowes Companies Inc. (LOW)

Lowes Inc. (LOW) has increased its dividend for over 50 years and has paid one each year since 1961. The company's revenue has steadily risen since 2016 from $56 billion to approximately $70 billion by Q1 2019. Annual profit or net income rose from $2.7 billion in 2016 to $3.4 billion in 2018.

From the chart below, we can see that the stock price rose from nearly $70 in 2016 to as high as $117 in 2018 before retracing back to ~$97.50 by year-end. Also, dividends rose from 28 cents in 2016 to 48 cents in 2018. Proponents of dividend signaling could point to Lowes as an example of executive management signaling that higher dividends should correlate to a higher stock price.

Image by Sabrina Jiang © Investopedia 2021

Special Considerations

In our examples above, we're only analyzing a few years' worth of data for two stocks. Many other factors also drive a stock price higher or lower besides dividends, including economic conditions, consumer spending, management effectiveness, sales, and earnings. Several other stocks with strong dividend-paying histories appear promising for investors seeking ever-increasing dividends, including National Fuel Gas Company, the FedEx Corporation, and the Franco-Nevada Corporation.