Signaling Safety

In this paper we revisit a classic idea in finance and economics, namely the hypothesis that dividend changes convey information about firms’ future prospects. Contrary to prior literature we find strong support for the dividend signaling hypothesis, provided we properly define “firms’ future prospects” as the second moment of firms’ future profits. In other words, we posit that dividends do convey a signal, but that the signal is about the second moment and not about the first moment. We find that changes in cash-flow volatility follow changes in dividend policy in the opposite direction both at the extensive margin, initiations and omissions, and at the intensive margin, dividend increases and decreases. Cash-flow volatility decreases, on average, by 15% in the five years after dividend increases relative to the prior five-year average, whereas it increases by 7% after dividend cuts. Furthermore, volatility decreases by 20% after dividend initiations and it increases by 6% after dividend omissions. In addition, announcements of larger changes in dividends come with larger cumulative abnormal returns and are followed by larger changes in cash-flow volatility. We conclude that dividend changes signal the safety of the firms’ future profits.

The idea that dividend changes convey information about firms’ future prospects has a long tradition in finance and economics dating back at least to Miller and Modigliani (1961). Miller and Rock (1985), Bhattacharya (1979), and others later formalize this idea, which can explain why dividend changes come with large announcement returns, but also predicts that changes in dividends should be followed by changes in earnings or cash flows in the same direction. However, numerous empirical studies have failed to find evidence supporting this mechanism. In their review paper, DeAngelo et al. (2009) discuss the evidence and write, “We conclude that managerial signaling motives [...] have at best minor influence on payout policy” (p. 95).

In this paper, we show dividends do convey information, but it is information about the second moment of earnings, and not about the first moment. We show both theoretically and empirically that dividend changes signal changes in cash-flow volatility in the opposite direction. We borrow a method from asset pricing, namely the Campbell and Shiller (1988a,b) return decomposition, to split movements in stock returns into parts coming from news about future cash flows and parts coming from news about future discount rates.

An advantage of this method is that it directly uses information in returns to infer cash-flow news rather than relying on balance-sheet variables such as earnings or cash flows that are only available at a lower frequency, are prone to manipulation in the short run, and are non-stationary in levels. Moreover, unlike total stock return volatility, our return decomposition establishes directly whether any variation around dividend events occurs because of news about future cash flows or discount rates, both for levels and second moments. Finally, an important benefit of the return decomposition is that we can provide novel evidence on changes in discount rates and the relation to corporate decisions (Cochrane (2011)). We find no significant change in discount-rate news around dividend events. This latter finding suggests discount-rate news does not drive corporate dividend policies.

To sum up, the paper’s contributions are threefold. First, it provides an innovative method in a corporate finance context to measure the first and second moment of future cash flows. Second, we provide a robust evidence that changes in payout policies are related to subsequent changes in the safety of firms’ cash flows. Third, we offer a simple model to rationalize our empirical results. Our static model simultaneously rationalizes our novel empirical results on payout policy and expected cash-flow volatility, as well as many results from the prior literature. The main takeaway of our analysis is that the riskiness of future cash flows is a significant determinant of firms’ payout policies.

Finally, it is worth mentioning that the method we employ to measure the moments of the distribution of expected cash-flows and discount rates, combined with our findings regarding firms’ conveying information about the second moment of future cash flows, suggests opportunities for future research exploring the motives of other corporate financial decisions. For example, Kogan et al. (2019) examine whether “unusually large” investment expenditures (i.e., “spikes”) are followed by lower cash-flow volatility, as implied by the exercise of real options, or by larger cash-flow volatility, as implied by agency theory. Our method may also be able to shed light on questions beyond finance. For example, a recent strand of research in economics has stressed ways in which aggregate uncertainty can affect firm investment dynamics (e.g., Bloom (2009), Bloom et al. (2007)). Researchers may now expand this line of reasoning to investigate the precise relevant source of uncertainty driving firms’ investment policies.