How Signaling Theory Can Be an Usefull for Investors - Essay Example

Introduction Signaling theory is considered as one of the most important theories to outline the behavior of two parties and how their behavior signals about certain outcome. It is based upon the information asymmetries which exist between the managers and the investors and signals about the future financial health and behavior of the firm. From the perspective of finance, this theory outlines that changes in the dividend and payout can actually signal changes in future cash flows. Dividend theory suggests that dividends are sticky and also signals the quality of the firm. Empirical studies however, critically not suggest a strong link between the signaling and the future performance of the firm. However, some empirical studies provided support to this hypothesis that costly dividend payouts by the firm effectively result into positive performance. Empirical evidence also indicates that managers may be reluctant to change the dividends and capital structure as market can infer from the various signals it can interpret from the overall actions of the managers. If effectively interpreted, signaling theory can offer investors and outsiders an important insight into how the mangers are going to act in future and what may be the future course of action in terms of changes in dividend payouts as well as the capital structure of the firm. This paper will provide theoretical and empirical evidence regarding how the signaling theory can explain the manager’s decision to change capital structure and payout policy. How stock markets actually react to these decisions will also be discussed. Signaling Theory This theory, in its basic form, stipulates that the changes in the dividend policy actually convey the information to the investors about changes in the future cash flows of the firm. This suggests a positive relationship between the information asymmetry and dividend policy of the firm. It outlines that if the overall information asymmetry is higher, the sensitivity of the dividends to the future prospects of the firm increases. The overall assumptions of this theory are based upon game theory suggesting that a manager spotting good investment opportunities tend to signal this to the market. Announcement of higher dividend payout signals to the market that there is actually a permanent improvement in the performance of the firm whereas a decrease in dividends suggests a decline in the managerial confidence. (Bhattacharya 1979)1 A major assumption of all signaling models is that firms are equity financed and outline the overall purpose of managers in paying of the costly dividends. These models tend to suggest that costly dividends are often paid in order to affect the share price of the firm. It is also important to note that high dividend payouts do not necessarily mean that the future prospects of the firm would be good. It has been argued that a higher dividend paid may indicate a reduction in the risk for the firm or the decline in the profitability of the firm. As such signaling theory can therefore outline as to whether the managers are planning to change the payout policy in future provided investors are able to separate two different components of the information being signaled by the dividends. (Brook, Charlton and Hendershott 1998)2 It is also important to note that market values the information which is more unexpected and have an impact on the prices in the market. The degree of information value of dividends signals to the market therefore actually depends upon the overall information asymmetry which exists in the market and between manager and investors particularly. The overall value of the signal therefore depends upon the existing information asymmetry in the market and whether the market has the ability to integrate news into its overall pricing mechanism easily and on time or not. signaling also suggests that the dividends should be paid to the shareholders according to the overall price of the share in the open market. (DeAngelo., DeAngelo & Skinner 1996)3 An important element therefore which can highlight the changes in the payout policies in the future is the depiction of the downside risk by the dividend payouts. For a conservative investor, managing downside risk is more important than a decrease in the payout ratio of the firm. It is therefore critical that the overall decision to understand what changes a dividend signal depicts outlines as to whether the investors will be able to assess the changes. More predictable the future earnings of the firms are and stable the dividend patterns better signals can be conveyed to the market. It is however, critical to note that various empirical studies have actually failed to find sign and the overall significance of information asymmetry on the dividend policy of the firm. Most of the empirical studies outlining the signaling hypothesis are based upon event studies wherein the events after the dividends are paid by the firms. Some empirical studies have focused upon understanding the revisions in earnings as a result of the unexpected changes in the dividends paid by the firms. Signaling theories also focus on understanding the changes in the structure of the firm after the announcement of the changes in the dividends. (Dewenter and Warther 1998)4 A study by Baker and Martin (2011) outlining the empirical results conducted on the companies listed on the New York Stock Exchange sought the views of the managers on the four different theories of dividends. Though all four has been agreed by the managers however, signaling has been considered as the major reason as to why managers pay dividends and change them to build future market expectations. It is also important to understand that the future of the firm’s performance and how it actually pays out the dividends largely focus on the present and future dividends to be paid by the firm. (Baker and Martin 2011)5 Empirical evidence also outlines that it is the quality of the earnings which determine the dividends and as such if dividend announcements are made despite the fact that firm may be facing adverse financial situation. There has been a renewed focus on understanding the quality of the earnings and its impact on the dividends. Studies also outline that the dividend behavior of the firm is determined by changes in the permanent earnings of the firm and suggests that the current earnings may not be the good indicator of the long term financial position of the firm. This may be the reason as to why managers may want to signal to the market regarding how they are willing to alter their payout ratio. (Cyert, Kang & Kumar 1996)6 Studies by Shirvani & Willbratte (1997) suggests that the when the overall payout ratio of the firm is below its long term target level, the manager is likely to increase the dividends. It therefore indicates that the higher payout ratio may signal the willingness of the managers to actually match the current payout ratio with that of the long term payout ratio. In this way, the theory can therefore outline the changes in the payout ratio. (Shirvani and Wilbratte 1997)7 It is also important to note that the signaling theory can help investors to understand the potential possibility of changes in the capital structure of the firm. Though the signaling theory is based upon the assumption that all firms are equity financed however, firms with combination of debt and equity can also use signaling theory to indicate about the potential changes in the capital structure of the firm. A higher dividend paid to the shareholders may signal that the firm is looking for new equity investors and is planning to raise the percentage of equity in its overall capital structure. Restrictive dividends on the other hand however signal that the managers are looking to attract more lenders and are attempting to portray a positive scenario to lenders by reducing their dividends. It is therefore can be inferred through signaling theory that the firms with higher level of debts or the firms looking to raise more debt have relatively low dividend payout ratios. (DeAngelo and DeAngelo 2011)8 Conclusion Signaling theory can be an effective theory for investors to predict and understand the behavior of the mangers. It outlines that the dividends paid by the managers actually signal about the future performance of the firm. There is a positive relationship between the dividends and the future performance as signaling theory outlines that dividends can suggest certain information about the future performance of the firm. There are two important interpretations regarding this i.e. dividends suggesting a change in the risk profile or the adverse performance of the firm. If a firm’s risk has declined a change in payout ratio can suggest an overall improved performance in the future however, if the firm’s performance has declined and firm increased the payout ratio, it may not serve its purpose. It has also been suggested that the higher dividends may signal that the managers may be looking for new equity investors. A higher payout ratio would indicate that the firm is willing to alter its capital structure and may look for more equity investors to support its new capital structure. On the other hand, a restrictive dividend may signal that the firm may be looking to attract new lenders and want to add more debt to its capital structure. Bibliography Baker, H. Kent, & Gerald S. Martin. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons, 2011. Bhattacharya, S. ‘Imperfect information, dividend policy, and “the bird in the hand’. Bell Journal of Economics and Management Science Vol.10, no. 1 1979: pp259-279. Brook, Y, W.T. Charlton, & R.J. Hendershott. "Do firms use dividends to." Financial Management vol. 27 1998: pp:46-57. Cyert, R., S.H Kang, & P. Kumar. ‘Managerial objectives and firm dividend policy: A behavioral theory and empirical evidence’. Journal of Economic Behavior & Organization Vol.31, no. 2 , 1996: pp:157-174. DeAngelo, H., & L. DeAngelo. ‘Controlling stockholders and the disciplinaryrole of corporate payout policy: A study of the Times Mirror Company.’ Journal of Financial Economics vol.56, no. 2, 2011: pp153-207. Dewenter, K.L., & V.A. Warther. ‘Dividends, asymmetric information, and agency conflicts: Evidence from a comparison of the dividend policies of Japanese and U.S. firms.’ Journal of Finance, vol. 53 1998: pp:879-904. H., DeAngelo, L DeAngelo, & D.J. Skinner. ‘Reversal of fortune dividend signalling and the disappearance of sustained earnings growth." Journal of Financial Economics vol.40, no. 3, 1996, pp: 341-371. Shirvani, H., & B. Wilbratte. ‘An empirical investigation of asymmetric behavior.’ Economic Inquiry Vol.35, 1997: pp:847-857. Read More