Dividends as Reference Points: A Behavioral Signaling Approach

by Malcolm Baker & Jeffrey Wurgler

Overview — While managers appear to view dividends as a signal to investors, managers also argue that standard dividend signaling models are not focused on the correct mechanisms. These standard models posit that executives use dividends to destroy some firm value and thereby signal that plenty remains: The "money burning" typically takes the form of tax-inefficient distributions, foregone profitable investment, or costly external finance. Executives who actually set dividend policy overwhelmingly reject these ideas yet, at the same time, are equally adamant that dividends are a signal to shareholders and that cutting them has negative consequences. In this paper, the authors develop what they believe to be a more realistic signaling approach. Using core features of prospect theory as conceptualized by Daniel Kahneman and Amos Tversky (the fathers of behavioral economics), they create a model in which past dividends are reference points against which future dividends are judged. The theory is consistent with several important aspects of the data. Baker and Wurgler also find support for its broader intuition that dividends are paid in ways that make them memorable and thus serve as stronger reference points and signals. Key concepts include:

  • The essence of Baker and Wurgler's stylized model is that investors evaluate current dividends against a psychological reference point established by past dividends.
  • This model is consistent with several facts about dividend policy that cannot be handled in static models.
  • This paper focuses on two central features of the prospect theory value function: that utility depends on changes in states relative to a reference point, and that losses bring more pain than symmetric gains bring pleasure.

Author Abstract

We outline a dividend signaling approach in which rational managers signal firm strength to investors who are loss averse to reductions in dividends relative to the reference point set by prior dividends. Managers with strong but unobservable cash earnings separate themselves by paying high dividends but retain enough earnings to be likely not to fall short of the same level next period. The model is consistent with several features of the data, including equilibrium dividend policies similar to a Lintner partial-adjustment model; modal dividend changes of zero, stronger market reactions to dividend cuts than increases, relative infrequency and irregularity of repurchases versus dividends, and a core mechanism that does not center on public destruction of value, a notion that managers reject in surveys. Supportive new tests involve nominal levels and changes of dividends per share, announcement effects, and reference point currencies of ADR dividends.

Paper Information

  • Full Working Paper Text
  • Working Paper Publication Date: July 2012
  • HBS Working Paper Number: NBER Working Paper Series, No. 18242
  • Faculty Unit(s): Finance