What is Dividend Signaling Hypothesis?



The companies that pay regular dividends generally use informational content to promote their status in the market. A company that pays regular dividends increasingly is appreciated more by investors which helps the company in collecting more benefits in terms of investment by the lenders, debtors, and investors in the market.

Therefore, companies that pay regular dividends use the information in their favor to increase the share prices or to attract more investment. This process of dividend signaling to investors is known as the dividend signaling hypothesis.

How Does Dividend Signaling Help Companies?

The MM model suggests that a company that is strong enough to pay increasing dividends attracts more investors than a company that does not offer dividends. That is why, the companies with a strong portfolio can use informational content in their favor. The dividend signaling hypothesis confirms the credential of such a company.

  • The dividend signaling hypothesis asserts that the most valuable dividend policy is the one that cannot be informed via any other communication channel. The dividend policies of a firm, therefore, are likely to closely reflect a firm’s long-standing dividend policy. By this reflection of performance in the market, the strong companies usually make a good impression in the market.

  • The dividend signaling hypothesis follows the firm’s competitive advantage in paying out dividends to its shareholders. By offering effective informational content with sufficient dividends, a company can create a favorable impression. These companies that can create a favorable impression can command better market share and share value.

The dividend signaling hypothesis shows the companies that are credible to offer increasing dividends among the vast repository of listed companies available in the share market.

Dividend Signaling in Growing Companies

One of the most important factors that affect the share prices of a company is whether the company is a mature one or is still in its growing phase.

  • The shareholders of a mature company are more interested in dividend income rather than capital gains, while the investors in a growing company are interested more in capital gains.

  • According to the dividend signaling hypothesis, mature companies can offer increasing dividends to their shareholders, while the growing companies keep the profits more as retained earnings.

  • The growing companies usually avoid paying dividends but they communicate the earning credentials to the shareholders to keep the latter informed about growth and future earnings.

In this way, the growing companies can attract investments by promoting informational content in the market.

Conclusion

The dividend signaling hypothesis shows the dividends a company is going to distribute to its shareholders. It is a matter of reflection of the company's performance in the market and it helps the investors realize the true potential of a firm's dividend distribution policy.


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