Asymmetric Information and Dividends (signalling)

Dividends as Signals

Another argument for higher dividends relies on the fact that investors are constantly seeking clues as to which companies are most successful. How can an investor separate the marginally profitable companies from the real money makers?One clue they can use is dividends.

Dividends as Signals

Accounting numbers may lie, but dividends require the firm to come up with hard cash.  A firm that reports good earnings, but does not back it up with generous dividends may be tweaking its numbers. But a high dividend policy will be costly to firms that do not have the cash flow to support it. Thus dividend increases signal a company’s good fortune and its managers’ confidence in its future cash flows.

Information Content of Dividends Since dividends are interpreted by investors as a signal about future earnings, announcements of dividend cuts are usually taken as bad news. The information content of dividends means that dividends are used as a source of information to investors about a firm’s future performance.

Dividends as Signals

Dividends as Signals

If dividends are taxed more heavily than capital gains, then a policy of paying high dividends would hurt firm value. Investors would avoid the shares of such firms, causing their stock price to drop. Plowing earnings back into the firm, instead of declaring dividends, would produce the capital gains desired by investors. Companies with high retention rates would be rewarded by investor demand for their shares and higher share prices.

Dividends as Signals

One of the key differences between dividends and capital gains is that taxes on dividends must be paid immediately. Taxes on capital gains are deferred until the shares are sold and the capital gains are realized. Thus, investors can control when they pay capital gains tax.

Dividends as Signals

Dividend Clientele Effects Even if a clientele existed for either high- or low-dividend yield stocks, as we have already seen, most such clienteles have already been satisfied. Thus, changing your firm’s dividend policy to suit that clientele would not lead to a change in the value of your firm’s shares. That is, changing your firm’s policy would lead to a switch in investors holding your firm’s shares, but it probably would not affect your firm’s value.

Share Repurchases Instead of Cash Div's?

From a firm’s perspective a share repurchase is very similar to paying a cash dividend. However, the tax treatment for investors may be quite different. A dividend leads to an immediate tax obligation. However, an investor has the option of not tendering his/her shares to a repurchase offer and thus avoiding the capital gains tax.