In recent years, there has been increasing pressure on U.S. corporations to distribute earnings to shareholders in the form of dividends. This Commentary explains that dividends are important, but investors can err by reading too much into them.Dividends

O. Emre Ergungor

English

Research Papers in Economics

Dividends
by O. Emre Ergungor
April 1, 2004
ISSN 0428-1276
In recent years, there has been in-
creasing pressure on U.S. corpo-
rations to distribute earnings to 
shareholders in the form of divi-
dends. This Commentary explains 
that dividends are important, but 
investors can err by reading too 
much into them. 
Dividends are back in vogue.  After 
the bear market and corporate mis-
haps of the past few years, investors 
have begun to pay more attention to 
the health of companies’ bottom lines 
instead of focusing solely on growth 
opportunities and future capital gains.  
As the Wharton economist Jeremy 
Siegel explained in a Wall Street 
Journal article, paying dividends is 
the old-fashioned, time-tested way 
companies show investors their earn-
ings are real and their bottom line is 
strong.1  A company can use account-
ing tricks to fake its earnings, but, so 
the argument goes, it cannot fake its 
dividend check.  The earnings have 
to be real and cash must be in the 
bank before the checks can be mailed.   
The ﬁ  nancial press seems to have ac-
cepted this view, and the beneﬁ  ts of 
dividends are touted almost without 
exception, and investors are urged to 
pressure company boards to initiate 
dividends or pay higher ones.
Dividends can indeed be useful to 
company insiders, who can use the 
dividend policy to convey informa-
tion to investors about the future pros-
pects of the ﬁ  rm.  But the information 
dividends send is not always clear 
cut, and investors need to consider 
some important factors when evaluat-
ing dividend announcements.  
  Does Dividend Policy 
Really Matter?
In a perfect market, where ﬁ  rms are 
transparent and investors can clearly 
see how a business will perform today 
and in the future, and where there are 
no taxes, bankruptcy costs, or trans-
action costs, dividend policy does not 
matter.  What matters for ﬁ  rm value 
is expected earnings and business 
risk, as Franco Modigliani and Mer-
ton Miller demonstrated in their now 
classic 1961 paper.  The way a com-
pany splits its earnings between divi-
dends and retained earnings affects 
nothing.2 
To see why this is so, suppose that 
after all the proﬁ  table investments 
are made, a ﬁ  rm still has some cash 
left over, which can be distributed to 
shareholders in part or in full.  The 
ﬁ  rm may even raise additional funds 
by issuing new shares or bonds and 
distribute the receipts to the share-
holders as dividends in excess of the 
leftover cash.  But Modigliani and 
Miller show that shareholders gain 
nothing from the management of divi-
dend payments.  All dividend policies 
are equivalent; management cannot 
create wealth by slicing and dicing 
the ﬁ  rm’s earnings.  
By paying a dividend, the ﬁ  rm ef-
fectively puts its cash into investors’ 
pockets.  The value of the ﬁ  rm de-
clines by the dividend amount be-
cause an asset (cash) has left the 
ﬁ  rm.  But shareholders are not bet-
ter or worse off because they are the 
recipients of the cash; the dividend 
payment exactly offsets the decline 
in share value.  In other words, pay-
ing a dividend is like transferring cash 
from one pocket of the shareholder 
to another; it has no impact on the 
shareholder’s wealth.  And of course, 
the same principle applies if the ﬁ  rm 
raises additional funds from the mar-
ket to pay dividends, so this approach 
has no impact on shareholder wealth 
either.
But what if a particular group of 
shareholders has a strong preference 
for cash in the pocket rather than the 
company vault—say, as a source of 
income—would dividend policy mat-
ter then?  The answer is still no.  Re-
call that in this perfect world, there 
are no transaction costs.  So any 
shareholder who prefers cash can ob-
tain it by selling some of his shares at 
no cost.  Conversely, if a ﬁ  rm is pay-
ing dividends, a shareholder who does 
not want to hold cash can undo the 
dividend payment by reinvesting it in the ﬁ  rm through a share purchase.  If 
investors can costlessly replicate any 
dividend policy, investors’ valuation 
of a ﬁ  rm would not be affected by 
that policy. 
Dividend policy may be irrelevant 
in a perfect market, yet we know 
that many of these perfect-market 
assumptions do not hold in today’s 
world.  After all, we observe transac-
tions costs, taxes, costly bankruptcy, 
and most importantly, private infor-
mation.  Any of these so-called “fric-
tions” could lead to an optimal divi-
dend policy for individual ﬁ  rms, but 
to illustrate the subtleties involved in 
interpreting the information dividends 
provide, we will focus on the implica-
tions of private (inside) information 
for dividend policy. 
   Dividends and Inside 
Information
Investors’ uncertainty about a com-
pany’s value is not limited to their 
uncertainty about the quality of cur-
rent earnings.  Insiders of a ﬁ  rm—its 
managers and directors—are like-
ly to have more information than 
shareholders about the future of the 
business as well. But getting this 
information to shareholders is not 
straightforward. Insiders may choose 
not to reveal more information to 
the market directly because doing so 
might require divulging trade secrets, 
which could beneﬁ  t competitors.  Or, 
if it is too costly to verify the truth-
fulness of insider comments about a 
ﬁ  rm’s future prospects, shareholders 
don’t consider such statements cred-
ible. Economic theory says that divi-
dend policy may be relevant in cases 
like this because dividends may allow 
insiders to signal—credibly—their 
beliefs about the future performance 
of the ﬁ  rm to the market.
To see where the credibility comes in, 
consider the following example.  Sup-
pose a ﬁ  rm’s managers anticipate that 
the business will do well in the future 
but ﬁ  nd it too costly to explain all the 
details to the shareholders directly.  
In addition, assume that the optimal 
investment strategy of the ﬁ  rm over 
time involves holding a certain level 
of cash assets on its balance sheet.  
One way to signal the managers’ posi-
tive assessment of the ﬁ  rm’s future 
performance prospects is to distrib-
ute a “sizeable chunk” of the ﬁ  rm’s 
cash as dividends.  The theory gives 
no precise deﬁ  nition for what a “size-
able chunk” is, nor does it tell us how 
the cash should be distributed: as one 
lump-sum payment or as higher an-
nual dividends over a long time hori-
zon. But it does say that the right-size 
chunk will be a credible signal be-
cause a ﬁ  rm will pay high dividends 
only if its management anticipates 
that future cash ﬂ  ows will be strong.  
If a ﬁ  rm is not successful, and inter-
nally generated funds are not enough 
to restore its cash position, managers 
may have to raise more funds from 
the market.  Tapping the market for 
fresh funds is costly because of in-
vestment bank and legal fees and the 
amount of managerial time it con-
sumes.  So only those ﬁ  rms whose 
managers anticipate strong future 
cash ﬂ  ows will pay high dividends. 
Firms uncertain about their future or 
sure that future cash ﬂ  ows won’t be 
sufﬁ  cient to restore their cash posi-
tion will choose a dividend policy that 
preserves cash holdings.  By observ-
ing a ﬁ  rm’s dividend policy in the 
context of other publicly available in-
formation on the ﬁ  rm, investors can 
infer the management’s private in-
formation about the business’s future 
prospects.3
But investors should not automati-
cally cheer every dividend announce-
ment or penalize ﬁ  rms for not pay-
ing dividends.  As is often the case in 
economics, the theory brushes away a 
number of important factors to make 
a simple point about dividend policy. 
These factors need to be explicitly ac-
counted for before the information 
content of dividends can be evaluated 
properly.
   Caveats
The most crucial factor investors 
must recognize is that paying divi-
dends represents a choice among al-
ternatives, and the alternatives have 
different costs and beneﬁ  ts. Divi-
dends are not the only way to in-
form shareholders about a business’s 
potential.  Share repurchases, stock 
splits, the amount of debt carried on 
the balance sheet, the level of capi-
tal investment, and the purchase and 
sale of the ﬁ  rm’s stock by insiders are 
some of the other ways the informa-
tion can be transmitted.  Dividends 
are not necessarily the cheapest or 
the best way to convey information.4  
Share repurchases and dividends, for 
example, are very similar in purpose 
but are used quite differently by man-
agers.  Surveys of chief ﬁ  nancial of-
ﬁ  cers indicate that both techniques 
are used primarily to convey positive 
information to the market.  But ﬁ  rms 
pay the same dividend amount every 
period, and the market interprets any 
deviation from this regular amount as 
a signal from management.  Repur-
chases, on the other hand, are unan-
ticipated events; the timing and size 
of the repurchases do not follow any 
pattern.  Moreover, ﬁ  rms often repur-
chase shares for reasons unrelated to 
information signaling.  For instance, 
a ﬁ  rm may repurchase shares for its 
employee stock ownership plan or for 
use in executive compensation.
Economists cannot yet fully explain 
why ﬁ  rms choose one method of dis-
tributing cash to shareholders over 
another, but the important point for 
investors to keep in mind is that each 
method provides one piece of a giant 
information puzzle. Dividends can 
help investors see the big picture if 
they can tie all the other bits and piec-
es of information together.5, 6  A divi-
dend increase or initiation alone does 
not make a good ﬁ  rm.  Neither does a 
lack of dividends necessarily make a 
bad ﬁ  rm.
The availability of alternative com-
munication techniques is not the only 
reason investors should not expect 
every ﬁ  rm to pay dividends.  After 
all, a critical factor in the decision to 
pay dividends is the relationship be-
tween the level and variability of the 
ﬁ  rm’s cash ﬂ  ows and the set of proﬁ  t-
able investments available to the ﬁ  rm.   
For example, the shareholders of a 
growth company may be better off if 
the company preserves its earnings to 
fund a multitude of investments rather 
than paying dividends.  For growth 
companies, internally generated funds 
may not be sufﬁ  cient to fund all of 
their future investment opportuni-
ties, and paying dividends would only increase the amount of outside 
funds that would need to be raised.  
The shareholders of a company in a 
mature industry—one in which in-
ternally generated cash exceeds what 
the company needs to reinvest in its 
operations—may be better off if the 
ﬁ  rm distributes the cash.  After all, 
managers of the ﬁ  rm are no better at 
investing excess cash than sharehold-
ers.  It is wrong to deduce that the 
mature ﬁ  rm has more good news than 
the growth ﬁ  rm just because it is pay-
ing dividends and the growth ﬁ  rm is 
not.  What matters is not the dividend 
announcement but how the announce-
ment ﬁ  ts the big picture.
The importance of paying attention 
to the big picture becomes especially 
apparent when one remembers that 
managers may know a lot about their 
company, but they can’t predict the 
future.  Managers can make mistakes; 
they may be subjective and wrong in 
their estimation of future earnings.  
A dividend increase may seem like 
a good decision at ﬁ  rst, based on the 
information available to the manager 
at the time, but it may turn out to be 
less wise as time goes by and new in-
formation comes in.  In other words, 
a change in dividend policy may con-
vey the upbeat information managers 
have at the time the change is made, 
but tell us nothing about the quality 
(precision) of that information.  Evi-
dence suggests that managers some-
times send inaccurate signals to the 
market using dividends.  
Occasionally, companies raise their 
dividends only to cut them back at a 
later time, once management realizes 
that the new level is not sustainable 
in the long run.  Sometimes managers 
make optimistic announcements and 
increase their companies’ dividends, 
but the companies continue to per-
form poorly for many years to come.7  
Because managers may send both ac-
curate and erroneous information us-
ing dividends and investors cannot 
discern between the two, a dividend 
initiation or increase should not be 
interpreted as a sure sign a ﬁ  rm’s per-
formance will improve.
Another danger of focusing too much 
on dividend announcements is if in-
vestors put too much emphasis on 
dividends, ﬁ  rms have an incentive to 
cut back on investments and pay high 
dividends instead.  Firms that invest 
too little in order to pay high divi-
dends will eventually be discovered 
by the market.  The long-run result 
will be a reduction in the market’s 
forecast of the ﬁ  rm’s future earnings 
and a consequent drop in its stock 
price.  Overemphasis on dividends 
may reduce ﬁ  rm value.8
   It Takes More than 
Dividends 
Paying dividends is one way ﬁ  rm in-
siders can put cash in the hands of 
shareholders and convey some infor-
mation that may be too costly to com-
municate directly.  The usefulness of 
dividend policy as a signaling device 
is well-established, but its message 
may be misleading if the empha-
sis is solely on whether or not a ﬁ  rm 
is paying dividends or whether the 
dividends are high or low.  Dividend 
policy is a useful communication tool 
in the corporate toolbox but not the 
only tool.  Consequently, the message 
dividends send is best understood 
when a dividend policy is viewed as a 
complement to all the other available 
information.
   Footnotes
1. Jeremy J. Siegel. 2002. “The Divi-
dend Deﬁ  cit,” Wall Street Journal, 
February 13, A20.
2. Merton H. Miller and Franco 
Modigliani. 1961. “Dividend Policy, 
Growth, and the Valuation of Shares,” 
Journal of Business 34, 411–33.
3. Sudipto Bhattacharya. 1979. “Im-
perfect Information, Dividend Policy, 
and the ‘Bird in the Hand’ Fallacy,” 
Bell Journal of Economics 10, 259–70.
4. Ramasastry Ambarish, Kose John, 
and Joseph Williams. 1987. “Efﬁ  -
cient Signaling with Dividends and 
Investments,” Journal of Finance 42, 
321–43.
5. John Kose and Larry H.P. Lang. 
1991. “Insider Trading around Divi-
dend Announcements: Theory and 
Evidence,” Journal of Finance 46, 
1361–89.
6. Larry H.P. Lang and Robert H. 
Litzenberger. 1989. “Dividends An-
nouncements: Cash Flow Signal-
ing vs. Free Cash Flow Hypothesis,” 
Journal of Financial Economics 24, 
137–54.
7. Harry DeAngelo, Linda DeAngelo, 
and Douglas J. Skinner. 1996. “Re-
versal of Fortune: Dividend Signaling 
and the Disappearance of Sustained 
Earnings Growth,” Journal of Finan-
cial Economics 40, 341–71.
8. Merton H. Miller and Kevin Rock. 
1985. “Dividend Policy under Asym-
metric Information,” Journal of Fi-
nance 40, 1031–51.
   Recommended Reading
For more detailed discussion on divi-
dends, I recommend the articles cited 
in the footnotes as well as:
John B. Carlson. 2001. “Why Is the 
Dividend Yield So Low?” Federal 
Reserve Bank of Cleveland, Economic 
Commentary, April 1.
Ronald C. Lease, Kose John, Avner 
Kalay, Uri Loewenstein, and Oded H. 
Sarig. 2000. Dividend Policy: Its Im-
pact on Share Value. Boston: Harvard 
Business School Press. O. Emre Ergungor is an economist at the 
Federal Reserve Bank of Cleveland. 
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