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Dividends As Reference Points: A Behavioral Signaling Approach

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Dividends As Reference Points: A Behavioral Signaling Approach

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Malcolm P. Baker

Harvard Business School; National Bureau of Economic Research (NBER)

Brock Mendel

Harvard University

Jeffrey Wurgler

NYU Stern School of Business; National Bureau of Economic Research (NBER)

January 22, 2015

Review of Financial Studies (Forthcoming)

NYU Working Paper No. 2451/31372


We outline a dividend signaling model that features investors who are averse to dividend cuts. Managers with strong unobservable cash earnings pay high dividends but retain enough to be likely not to fall short next period. The model is consistent with a Lintner partial-adjustment model, modal dividend changes of zero, stronger market reactions to dividend cuts than increases, comparatively infrequent and irregular repurchases, and a mechanism that does not depend on public destruction of value, which managers reject in surveys. New tests involve stronger reactions to changes from longer-maintained dividend levels and reference point currencies of American Depository Receipt dividends.

Dividends As Reference Points: A Behavioral Signaling Approach - Introduction

Managers share a number of common views about their dividend policies, as shown in the survey by Brav, Graham, Harvey, and Michaely (2005). They strive to avoid reducing dividends per share (of the 384 managers surveyed, 93.8% agreed); they try to maintain a smooth dividend stream (89.6%); and, they are reluctant to make changes that might have to be reversed (77.9%). They follow such policies because they believe that there are negative consequences to reducing dividends (88.1%), which they believe convey information to investors (80%). While caution is merited in interpreting survey responses, the Brav et al. results are further consistent with Lintner’s (1956) own survey and interviews, his partial-adjustment model, and a large empirical literature demonstrating a significant response to dividend announcements.

While managers view dividends as some sort of signal to investors, they also cast doubt on the mechanisms of standard dividend signaling models. For example, the proposition that dividends are used to show that their firm can bear costs such as borrowing external funds or passing up investment was summarily rejected (4.4% agreement, the lowest in the entire survey). The idea of signaling through costly taxes did not receive much more support (16.6%). Again, while we might not expect managers to admit public destruction of value even in an anonymous survey, these findings suggest there is more to the story than the economic mechanisms driving well-known signaling models such as Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985), Kumar (1988), Bernheim (1991), Allen, Bernardo, and Welch (2000), and Guttman, Kadan, and Kandel (2010).

In this paper we use loss aversion, a feature of the prospect theory value function of Kahneman and Tversky (1979), to motivate a behavioral signaling model. A loss-averse value function has a kink at the reference point whereby marginal utility is discontinuously higher in the domain of losses. Loss aversion is supported by a considerable literature in psychology, finance and economics, as we briefly review later.

The essence of our stylized model is that investors evaluate current dividends against a psychological reference point established by past dividends. Because investors are particularly disappointed when dividends are cut, dividends can credibly signal information about earnings. The model is inherently multiperiod, which leads to more natural explanations for the survey results above and other facts about dividend policy such as the Lintner partial-adjustment model, which emerges in equilibrium, and which static signaling models cannot address. While it is difficult to measure investor utility functions per se outside the laboratory, we perform some novel tests that get at the core intuitions of the approach.

To provide a bit more detail, the model uses reference point preferences as the mechanism for costly signaling. The manager’s utility function reflects both a preference for a high stock price today and for avoiding a dividend cut in the future. In the first period, the manager inherits an exogenous reference level dividend, and receives private information about earnings. The manager balances the desire to signal current earnings by paying higher dividends with the potential cost of not being able to meet or exceed a new and higher reference point through the combination of savings from the first period and random second-period earnings. In equilibrium, managers that cannot meet the inherited dividend level pay out everything in the first period, as the marginal cost of missing the reference point is high; managers with intermediate first-period earnings pool to pay the reference dividend; and managers with strong first-period earnings pay out a fraction that raises the reference level for the future but, given their savings and expected second-period earnings, to a level they are relatively confident that they can maintain.

This simple model is consistent with several facts about dividend policy that cannot be handled in static models. First, the modal dividend change is zero. In a rational continuous setting, there is no special significance to paying the same dividend as last period.1 Second, for reasonable parameter values, firms with high or stable earnings engage in a partial-adjustment policy that resembles the Lintner model. Third, firms are punished more for dividend cuts than they are for symmetric raises, and so avoid raising the dividend to a level that will be difficult to sustain. Fourth, the approach offers an explanation for why repurchases are less frequent than dividends despite their tax advantage: Unlike dividends per share, the parameters of a hypothetical “regular” repurchase program cannot be specified in salient and repeatable numbers. Fifth, the approach is intuitively compatible with the widespread practice of paying dividends in round numbers. Finally, the mechanism of the model is novel and not inconsistent with the available survey evidence. Strong types do not publicly burn money with certainty, but rather they implicitly burn expected utility by risking falling short the next period; for reasonable parameter values, actual utility burning by strong firms does not usually occur in equilibrium.


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