R2 and the corporate signaling effect

• Published date: 01 December 2021
• Author: Wei Hao,Udomsak Wongchoti,Martin Young,Jianguo Chen
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/irfi.12331

ORIGINAL ARTICLE

R

2

and the corporate signaling effect

Wei Hao | Udomsak Wongchoti | Martin Young | Jianguo Chen

Massey University, Palmerston North,

New Zealand

Correspondence

Martin Young, Massey University, Palmerston

North, New Zealand.

Email: m.young@massey.ac.nz

Abstract

If corporate announcements provide additional signals

about firms' future prospects, the degree of investors'

dependency on these news should vary with the relative

importance of firm-specific information on such publicly

traded firms. We show that price, volume and volatility

reactions to dividend change announcements are signifi-

cantly stronger for less synchronized firms (e.g., low R

2

stocks). This indicates that lower R

2

stocks are less informa-

tive and thus more surprises on firm-specific news are

experienced. These findings are particularly strong for divi-

dend decrease announcements. We also show that signals

about firms' earnings prospects from dividend decrease

announcements are more reliable among these companies.

KEYWORDS

dividend signaling effect, price synchronicity, R

2

JEL CLASSIFICATION

G14; G35

1|INTRODUCTION

A firm's R

2

(also known as stock price synchronicity) has been well established as the measure of the relative impor-

tance of firm specific information in its stock price movement variations. Specifically, lower stock price synchronicity

(low R

2

) has been widely employed as an indicator of higher stock price informativeness in numerous financial and

accounting research. However, whether low R

2

genuinely represents high stock price informativeness still remains

an ongoing debate. Event studies offer a particularly promising venue to address this important question further as

†

We acknowledge valuable research insights and supports from Zhuhui Liang, Yuk Ying Chang, Ben Marshall, Andy Prevost, David Tripe, Fei Wu, and the

participants at the FMA Annual Meeting 2012 in Atlanta. All errors are our own responsibilities.

Received: 28 August 2019 Revised: 21 July 2020 Accepted: 4 August 2020

DOI: 10.1111/irfi.12331

© 2020 International Review of Finance Ltd (IRF)

International Review of Finance. 2021;21:1353–1381. wileyonlinelibrary.com/journal/irfi 1353

they allow researchers to empirically investigate investors' responses to releases of firm-specific information, which

can be observed in the price and trade dynamics within a stock market. Yet, they are limited in the literature.

1

We

provide an alternative look into the issue by studying the “corporate”signaling effect (e.g., dividend change

announcements) conditional on stock price synchronicity.

There are two strands of thought with opposing views in interpreting R

2

. Building on the seminal work of

Roll (1988), the more traditional strand of literature proposes that low R

2

relates to better stock price informative-

ness with greater amount of firm-specific information being incorporated into the stock price (Durnev, Morck, &

Yeung, 2004; Durnev, Morck, Yeung, & Zarowin, 2003; Morck, Yeung, & Yu, 2000; among others). Specifically, Jin

and Myers (2006) postulate that some firm-specific information is “never”disclosed as managers deliberately hide

information. This, in turn, results in uneven firm-specific information flowing from managers (insiders) to investors

(outsiders). Thus, higher synchronicity with the stock market (e.g., high R

2

) is associated with more severe opacity of

a firm. In other words, some firm-specific information of such firm is persistently hidden, making its stock price less

informative. However, another strand of literature suggests that low R

2

actually represents poorer information envi-

ronment in which firms are less timely in disclosing firm-specific information to investors (Dasgupta et al., 2010;

Devos et al., 2015; Hao, Prevost, & Wongchoti, 2018).

In the context of event studies, Dasgupta et al. (2010) have argued, based on their theoretical model, that firm-

specific information of a publicly traded firm should be disclosed “sooner or later”(rather than never). This is consis-

tent with empirical observations by Kelly (2014) and Li, Rajgopal, and Venkatachalam (2014) that US publicly traded

firms with higher R

2

tend to be more established firms with bigger size, higher liquidity, and better disclosure quality.

The relatively more timely disclosure of these higher R

2

firms allows investors to better learn the price variation in

the future. It follows that there will be less surprise (and thus less reaction) to announcements observed by the public

for high R

2

firms since relatively more firm-specific information regarding firms' fundamentals would have already

been impounded in stock prices. In other words, firms with higher stock price synchronicity are actually related to

more timeliness in disclosing firm-specific information (e.g., less severe in opacity). Stocks with higher (lower) R

2

are

therefore less (more) responsive to announcements to the public. This view is testable but largely ignored in the con-

text of “corporate”signaling effect and we intend to fill this gap.

We begin our analysis by examining the signaling effects of dividend change announcements (dividend increases

and dividend decreases) on stock market reactions conditional on different R

2

levels. Our results for US stocks during

the 1950 to 2012 period show that price, volume and volatility reactions to both dividend increase announcements

and dividend decrease announcements are indeed stronger for stocks with lower levels of R

2

and the magnitude of

reactions decreases monotonically with the increase of R

2

levels not only on the announcement day but also on days

around the announcement. However, this relation is more prominent among dividend decrease announcements.

These findings also hold in the cross-sectional analysis with inclusion of other control variables including the magni-

tude of dividend changes and firm size, among others.

The above findings extend the existing literature in two major ways. First, by showing that there is an adverse

relation between price synchronicity and the magnitude of stock reaction to firms' announcements, we add further

to limited empirical evidence for the more recent and novel view that lower R

2

stocks are actually less informative.

This view is formalized in the Dasgupta et al. (2010) theoretical model

2

but has never been formally tested in the

context of the corporate signaling effect. Second, while there is established empirical evidence in the dividend signal-

ing literature regarding the positive (negative) price responses to dividend increase (decrease) announcements, no

direct link has yet been made between the relative importance of “firm-specific”information and the magnitude of

the price impact. Thus, our study lends further support to the view that investors perceive dividend change

announcements as providing signals about specific firms' future prospects (e.g., Aharony & Swary, 1980; Bajaj &

Vijh, 1990; Pettit, 1972; Nissim & Ziv, 2001; and Amihud & Li, 2006). This is especially true for firms with inferior

(slower) information disclosure.

In this study, we also further investigate whether the ability of dividend changes to predict future earnings is

stronger among lower R

2

stocks. Classical theoretical work suggests that dividend payments provide a reliable signal

1354 HAO ET AL.