The Signaling Effect of Repurchase
Would management be more likely to launch a share repurchase program if the firm’s stock is overvalued or undervalued? While many companies implement share repurchase programs irrespective of whether the stock price is too low or too high, there is evidence that firms are more likely to buy stock that is undervalued by the market. Thus, some investors will consider the start of a stock buyback program as a signal that management thinks the stock is undervalued. Two studies that find evidence supporting this signaling effect are Dann (1981) and Vermaelen (1981).
Investors Like Dividends
The attitude of investors is an important factor to be considered. Consistently increasing dividends are generally welcomed by investors as indicators of profitability and safety. Uncertainty is increased by lack of dividends or dividends that fluctuate widely. Grigoli (1986) agrees with this conclusion: “Because investors value stable dividends, it may not be in a corporation’s best interests to raise dividends to unsustainable levels.”4
Dividends are thought to have an information content; that is, an increase in dividends means that the board of directors expects the firm to do well in the future. This “signaling effect” might favorably affect the firm’s common stock price. On the other hand, if income expectations do not justify the optimism, the indication of a more positive future than is justified by the facts is not likely to lead to a favorable outcome.
Since trust officers can only invest in securities with a consistent dividend history, firms like to establish a history of dividends so that they can make the “trust legal list.” This consideration sometimes leads to the payment of cash dividends before the firm would otherwise start paying a dividend.
Another important reason for the payment of dividends is that a wide range of investors need the dividends for consumption purposes. Although such investors could sell a portion of their holdings, this latter transaction has relatively high processing costs compared with cashing a dividend check. The presence of investors desiring cash for consumption makes it difficult to change the current dividend policy. One group of investors may benefit from a change in dividend policy, but another group may be harmed. Although we see that income taxes paid by investors tend to make a retention policy more desirable than cash dividends, the presence in the real world of zero tax and low tax investors needing cash dictates that we consider each situation individually and be flexible in arriving at a dividend policy.
There are stockholders who desire cash. A dividend supplies cash without the investor incurring brokerage expense. If cash is retained by the corporation, the stockholders wanting liquidity will have to sell a fraction of their holdings to obtain cash, and this process will result in brokerage fees. Retired individuals living off their dividends and tax-free universities are apt to prefer dividend-paying corporations to corporations retaining income. While a 100% earnings payout cash dividend has the advantage of giving cash to those investors who desire cash, the policy also results in cash being given to those investors who do not desire cash, and who must incur brokerage fees to reinvest the dividends, and who pay taxes.
Dividend Changes and Signaling
A study by Liu, Szewczyk, and Zantout (2008) shows that “there is no compelling evidence of a post-dividend-reduction or post-dividend-omission price drift” (p. 987).
Assume that a firm’s stock is fairly priced. Let us assume that this firm’s management thinks that if dividends are increased, the market will conclude that this is a favorable signal and the stock price will increase significantly. If the stock was fairly priced to begin with, the stock price after the dividend increase will be too high. This means that with no other changes, the new stockholders will earn less than the firm’s required return on stock. Thus, if a stock is fairly priced initially, an increase in dividends that leads to an unjustifiable stock price is not desirable since it leads to investor returns that are less than those required by the new stockholders.