Intro to Signaling

‍

‍

Signalling is an interesting approach used by investors. It combines many factors like insider trading, tech analysis, buybacks, debt and other market signals to determine if a stock will rise or not.

Today is somewhat like an intro class to signalling, where we will focus on dividends.

‍

‍

The Paper trails 💸

Alright so what’s the big deal ? Why should you be interested in the big payouts the firms give to the big dick shareholders. Well let me lay it out for you.

Dividend signaling: is a theory that suggests that a company's announcement of an increase in dividend payouts is an indication of positive future prospects.

‍

The reasoning behind it is rather simple. If you as an investor monitor a companies cash flow, meaning how much cash the company generates from operations. If the company is profitable, it should generate positive cash flow (obviously), But if a firm is really dripping in money and generates more profit than they know what to do with it, They set aside a chunk into retain earnings to pay out or increase dividends. Retain earnings is like a savings pot for a company that accumulates excess profits to be paid out to shareholders or invested back into the business.

‍

PROFITABILITY

The dividend signaling theory suggests that companies paying the highest level of dividends are, or should be, more profitable than otherwise identical companies paying smaller dividends. So, Increasing a company's dividend payout may predict favorable performance of the company's stock in the future.

‍

‍

Real World Example

‍

‍

Coca-Cola Corporation (KO)

‍

Coca-Cola Corporation (KO) has been increasing its dividend for over 50 years and began paying dividends in 1920.

The interesting thing that can be seen here is KO's revenue has declined in recent years. The company was profitable but it’s revenue and thus profits weren’t increasing. Despite this, dividends kept increasing.

From the chart , we can see that the stock price rose from nearly $41 in 2016 to $50 in 2018.

Each year dividends increased, outlined at the bottom of the chart, which supports the theory that increasing dividends can be indicative of a higher future stock price.

There are more examples of this. A quick google and you should find plenty.

‍

There’s a reason it’s called a “Theory”

‍

‍

The concept of dividend signaling has been widely contested. Because the dividend signaling theory has been treated skeptically by analysts and investors, because of this it has been regular tested. On the whole, studies indicate that dividend signaling does occur.

Increases in a company's dividend payout generally forecast a positive future performance of the company's stock and visa versa.

Two of the main studies done on the method were by two professors at the Massachusetts Institute of Technology (MIT), James Poterba and Lawrence Summers. Who concluded the theories that dividends signal some private information about profitability.

While earlier studies, conducted from 1973 to 1978, concluded that a firm’s dividends are basically unrelated to the earnings that follow.

Just thought I would add it so you know the whole picture.

‍

‍

‍

‍

‍

‍