Reading: Lesson 2 - Information Content, or Signaling, Hypothesis & Implications for Dividend Stability

1. Clientele Effect

1. As we indicated earlier, different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, retired individuals, pension funds, and university endowment funds generally prefer cash income, so they may want the firm to pay out a high percentage of its earnings. Such investors are often in low or even zero tax brackets, so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received—after first paying income taxes on those dividends.
   
2. If a firm retains and reinvests income rather than paying dividends, those stockholders who need current income would be disadvantaged. The value of their stock might increase, but they would be forced to go to the trouble and expense of selling some of their shares to obtain cash. Also, some institutional investors (or trustees for individuals) would be legally precluded from selling stock and then “spending capital.” On the other hand, stockholders who are saving rather than spending dividends might favor the low- dividend policy: The less the firm pays out in dividends, the less these stockholders will have to pay in current taxes, and the less trouble and expense they will have to go through to reinvest their after-tax dividends. Therefore, investors who want current investment income should own shares in high–dividend payout firms, while investors with no need for current investment income should own shares in low–dividend payout firms. For example, investors seeking high cash income might invest in electric utilities, which averaged a 78% payout in May 2012, while those favoring growth could invest in the semiconductor industry, which paid out 42% during the same time period.
   
3. To the extent that stockholders can switch firms, a firm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However, frequent switching would be inefficient because of (1) brokerage costs, (2) the likelihood that stockholders who are selling will have to pay capital gains taxes, and (3) a possible shortage of investors who like the firm’s newly adopted dividend policy. Thus, management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary but might also be permanent— if few new investors are attracted by the new dividend policy, then the stock price would remain depressed. Of course, the new policy might attract an even larger clientele than the firm had before, in which case the stock price would rise.
   
4. Evidence from several studies suggests that there is, in fact, a clientele effect. For example, low-tax or tax-free institutions hold relatively more high-dividend stocks than taxable investors, and taxable institutions hold fewer high-dividend stocks than non-taxed investors.15 MM and others have argued that one clientele is as good as another, so the existence of a clientele effect does not necessarily imply that one dividend policy is better than any other. However, MM may be wrong, and neither they nor anyone else can prove that the aggregate makeup of investors permits firms to disregard clientele effects. This issue, like most others in the dividend arena, is still up in the air.
   

2. Information Content, or Signaling, Hypothesis

1. When MM set forth their dividend irrelevance theory, they assumed that everyone— investors and managers alike—has identical information regarding a firm’s future earnings and dividends. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments, and managers have better information about future prospects than public stockholders.
   
2. It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock and that a dividend cut generally leads to a stock price decline. Some have argued this indicates that investors prefer dividends to capital gains. However, MM saw this differently. They noted the well-established fact that corporations are reluctant to cut dividends, which implies that corporations do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher than expected dividend increase is a signal to investors that the firm’s management forecasts good future earnings. Conversely, a dividend reduction, or a smaller than expected increase, is a signal that management is forecasting poor earnings in the future. Thus, MM argued that investors’ reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is important information, or signaling, content in dividend announcements.
   
3. The initiation of a dividend by a firm that formerly paid no dividend is certainly a significant change in distribution policy. It appears that initiating firms’ future earnings and cash flows are less risky than before the initiation. However, the evidence is mixed regarding the future profitability of initiating firms: Some studies find slightly higher earnings after the initiation but others find no significant change in earnings.What happens when firms with existing dividends unexpectedly increase or decrease the dividend? Early studies, using small data samples, concluded that unexpected dividend changes did not provide a signal about future earnings. However, more recent data with larger samples provide mixed evidence.18 On average, firms that cut dividends had poor earnings in the years directly preceding the cut but actually improved earnings in subsequent years. Firms that increased dividends had earnings increases in the years preceding the increase but did not appear to have subsequent earnings increases. However, neither did they have subsequent declines in earnings, so it appears that the increase in dividends is a signal that past earnings increases were not temporary. Also, a relatively large number of firms that expect a large permanent increase in cash flow (as opposed to earnings) do in fact increase their dividend payouts in the year prior to the cash flow increase.
   

3. Implications for Dividend Stability

1. The clientele effect and the information content in dividend announcements definitely have implications regarding the desirability of stable versus volatile dividends. For example, many stockholders rely on dividends to meet expenses, and they would be seriously inconvenienced if the dividend stream were unstable. Further, reducing dividends to make funds available for capital investment could send incorrect signals to investors, who might push down the stock price because they interpret the dividend cut to mean that the company’s future earnings prospects have been diminished. Thus, maximizing its stock price probably requires a firm to maintain a steady dividend policy. Because sales and earnings are expected to grow for most firms, a stable dividend policy means a company’s regular cash dividends should also grow at a steady, predictable rate.19 But, as we explain in the next section, most companies will probably move toward small, sustainable, regular cash dividends that are supplemented by stock repurchases.