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On this lecture, i have got mixed up on the term signalling effect and clientelle effect. The terms mean that the shareholders are upset when they get poor dividend. So what was really the point of these terms? What is their main difference? I further researched other online resources and ended very confused. Please help!
The difference is perhaps best seen by examples:
Suppose you are a shareholder, and every year your dividend has been increasing nicely. This year I tell you that there will be no dividend.
Your immediate reaction is likely to be to assume that the company is having problems and if the majority of shareholders think that, then the share price will fall.
(Even though no dividend might not be because there are problems, but because they have decided to do a lot of investing to expand the company).
That is the signalling effect. A change in the dividend immediately makes you think that things are better or worse when in fact they might not be.For clientele affect:
Some companies pursue a policy of always paying a high dividend – they do not retain much of their earnings and therefore although they pay high dividends, they do not grow much.
Other companies have a policy of paying low dividends – they retain a lot of their earnings, and so although the dividend is low, the company will be growing a lot.Investors choose their investments depending which they prefer. For example, an old person might prefer to invest in the company that pays high dividends because they need the income and are not bothered about future growth.
A young person might prefer the company paying lower dividends because they are less in need of the income and prefer growth.If I am an old person and have deliberately invested in the company that pays high dividends, I am going to be very unhappy if the company then decides to change its policy and in future is going to pay low dividends but have growth – if I had wanted that then I would have invested in a different company in the first place!
Hope that helps 🙂
Thanks! Retained earnings can be used as a source of finance but its drawback is that it reduces dividends payable to shareholders hence signalling and clientele effect. So companies would avoid using retained earnings for growth if such would affect the dividend position of its shareholders. Public issue or rights issue is an alternative. On the rights issue, the total number of shares increases for little change in total in total worth. Hence the share price value goes down. This is an internal valuation but how does that affect the stock exchange market value? Suppose the market will still maintain the original market price because they have confidence in the company? Is the ex theoretical market price connected to actual market price? Pls help!
Companies will not avoid using retained earnings – it is the most common way of raising finance and is the only way of achieving constant growth year on year.
What companies to tend to do is have try to have a stable dividend policy and communicate it to shareholders. It is when they change their policy for any reason that there is the possibility of the signalling and/or clientele effect.
With regard to rights issues, I don’t know what you mean by an ‘internal valuation’. As I explain in my lecture on rights issues, the theoretical ex-rights price does not take into account what the company is doing with the money raised. Usually the actual market price is higher than the TERP because shareholders expect the money to be invested well (although it is usually still lower that the original market price).
Aha! great! I really wanted this assertion “Usually the actual market price is higher than the TERP because shareholders expect the money to be invested well (although it is usually still lower that the original market price).” Thank you very much!
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