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Dividend signaling is a theory in economics that a company’s dividend announcements provide information about future earnings. Under this theory, if a company indicates that dividends will increase, this means it anticipates higher earnings in coming years. Researchers have extensively studied dividend announcements and financial records to determine whether this theory holds true in practice. The results of their research have been mixed, indicating that while dividend signaling can be a predictive tool in some cases, in others it may more accurately reflect past economic developments.
Companies use dividends to share profits with stockholders. They can decide to issue a dividend when plowing profits back into the company for development and growth isn’t necessary or practical. At the time officials make the decision to offer a dividend, they usually make an announcement, providing information about the amount and date so shareholders know what to expect. These announcements are closely anticipated and followed because investors believe they can provide information about the company’s financial health.
If a company is not offering dividends, this could indicate that it is investing heavily with the goal of growing, or that it is not doing well financially and cannot afford profit-sharing measures. Frequent high dividends can mean that a company is doing well, but could also be a warning sign that a company is not investing in new assets, maintenance, and growth activities. Proponents of dividend signaling argue that when a dividend announcement includes an increase, it means the board of the company feels confident about future earnings.
Support for this theory can be found in the argument that if a company expects to earn more, it may also expect to be able to pay out more in profit-sharing to shareholders. It could also use the dividend announcement as a tool to make a coded signal to investors with the goal of increasing confidence. By demonstrating a belief that it will do well in future years through dividend signaling, the company can make investors feel more comfortable, which may drive the value of stock up.
Some research does indicate that dividend signaling may be accurate, and some companies do indeed issue announcements for larger dividends when they are predicting large profits. Other studies show that this is actually a reflection of past profits; a company increases the size of its dividends after doing well, when it feels comfortable distributing more profits to shareholders because it doesn’t need to retain funds for emergencies or growth activities.