DIVIDENDS SIGNALING EFFECTS: UNDERSTANDING INFORMATIONAL VALUE OF DIVIDEND POLICIES
A company’s management and its board are the ultimate insiders. If they don’t know what is going on with the company, no one does. So, when the management starts declaring dividends, such a move is generally associated with increasing future earnings and cash flows. Also, when dividends are reduced or omitted, this generally invokes serious doubt whether future earnings and cash flows will be increasing somewhat or if at all.
Informational Value of Dividends
Informational value of dividends is great indeed. When dividends are regularly increased, such policy tells shareholders that the management expects earnings to grow in the future and that the company plans to make even more generous allowances from retained earnings, out of which dividends are usually paid.
ExxonMobil is a good example of a company proud of its record of continuously increasing dividends over the past two decades. Granted, the company has had its ups and downs when it came to earnings, cash flows and yields. However, the one constant year after year were increasing dividends, which effectively communicated to the market that the management’s long-term outlook remained positive, regardless how much earnings fluctuated in the meantime.
On the other hand, if, after such an untarnished record, ExxonMobil were to cut its dividends (either partly or altogether), such a move would have sent a loud and clear message to investors that “…something is rotten in the state of Denmark.”
Characteristics of Companies with Consistently Increasing Dividends
Companies that maintain and regularly increase their dividends share certain traits. Among other things, such companies either operate in niche market segments and/or hold dominant positions within their industries. More often than not, such companies will also have significant exposure to global markets, resources and labor force.
Furthermore, companies that regularly increase dividends typically have high returns on assets and low debt ratios. Having a low debt ratio is particularly important because it means the company is not likely to be restricted in its operating and financial decisions by debt covenants.
Communicating Counterintuitive Signals
In 1993, IBM attempted to send a counterintuitive (positive) signal by cutting its dividend. So, after years of having increased dividends, IBM, already a dominant force in the mainframe computer manufacturing, cut its dividend by more than a half. The company explained this unprecedented move with its intention to shift its business focus from mainframe to personal computers.
At the time, the market did not interpret IBM’s dividend cut favorably. However, with hindsight vision being 20/20, the company’s decision to keep its retained earnings as strong as possible should have been interpreted as a positive signal.
It was not as if the mainframe technology was obsolete, at least not yet. But IBM realized that if the company wanted to achieve aggressive growth rates of the past again, it would have had to focus on, and invest into, new technologies. More importantly, savvy investors, who knew how to “listen” more intently and how to read between the lines, were well rewarded for their efforts and patience.