R² and the Signalling Effect

Abstract:     
If investors perceive dividend changes as providing signals about specific firms’ future prospects, it can be argued that the magnitude of stock price reactions to dividend change announcements will vary with the relative importance of the firms’ specific information in their return dynamics. We find that price reactions to dividend announcements are significantly stronger for stocks with lower levels of R2. This finding is more pronounced and more robust for dividend increase announcements. In terms of the real signal about earning prospects, we show that current year dividend changes are more correlated to future earnings among stocks with lower levels of R2. In this case the relationship is stronger for dividend decrease announcements and sensitive to firm size. Taken together, our results support the traditional view that dividend announcements signal information about firms’ prospect to the stock market. At the same time we highlight the complexity of such dynamics, especially the discrepancy between investors’ expectation and the real signal conveyed by the firms about their future prospects. Our empirical framework can be generalized to apply to other signalling effects in literature.

Number of Pages in PDF File: 45

Keywords: Dividend signalling effect, R²

JEL Classification: G14, G35

working papers series