Do Dividend Initiations Signal Firm Prosperity?

In this paper we study the significance of dividend initiations in the context of firm performance, risk, and shareholder returns. Our evidence contradicts the principal implication of the signaling hypothesis that increase in dividend rate is positively related to future firm prosperity. We observe that firms report improving profitability, cash flow and other performance measures leading up to dividend initiation, but subsequently there is significant and sustained reversal across all these measures. We also observe that share prices react positively to dividend initiation announcements, suggesting that they are not anticipated by investors and are interpreted as positive news. However, over the five-year period subsequent to dividend initiation stock returns are significantly lower than that of the market, indicating that investors initially underestimate the deterioration in future profitability and performance of dividend-initiating firms. An observed decline in firms’ market-to-book ratios over this period suggests that investors eventually lower their initial expectations of firm growth and prosperity.