Dividend Changes and Signaling of Future Cash Flows

Abstract

We present fresh evidence on the validity of the dividend signaling hypothesis (DSH), by using a new testing approach. We test the unambiguous prediction from the DSH that the association between current dividend changes and future profitability is stronger for firms with higher marginal net benefits from signaling. Using a simple dividend signaling model, we derive three empirically identifiable drivers of the marginal net benefit of signaling: cash flow predictability, market-to-book, and past equity returns. Our empirical tests support the DSH. There is a significant association between current dividend changes and future earnings performance for firms with low cash flow predictability, low market-to-book ratio, and low past equity returns. But, as predicted by the DSH, the association is much weaker for firms with high cash flow predictability, high book-to-market, and high past equity returns. There is also evidence that the marginal signaling benefits at the firm-level are influenced by aggregate factors: the information content of dividend changes is time-varying, increasing (decreasing) in booms (recessions) and in periods of high (low) aggregate stock market performance.