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Summary
In their article, Baker and Wurgler (2004) described a completely new dividend theory in rich detail. Their core argument was that the investor demand could be dependent on time, making dividend-paying and non-dividend-paying stocks fluctuate. The importance of these findings can be explained by the fact that managers could become prone to catering to investor demand in an attempt to place premiums on certain stocks (mainly dividend-paying) (Baker and Wurgler, 2004). The theory proposed by the authors of the article was based on relevant empirical evidence revolving around the idea that there could be a positive relation between dividend premium measurements and aggregate dividend initiations. Accordingly, Baker and Wurgler (2004) found that the propensity to pay dividends could also be directly linked to dividend premiums. Based on a detailed review of the given article, it can be concluded that two significant issues with Baker and Wurgler’s (2004) study must be assessed for a better understanding of the subject.
The primary challenge that quickly becomes tangible when discussing Baker and Wurgler’s (2004) article is the presence of only two entities in the empirical model classification: nonpayers and dividend payers. This would ultimately lead the managers to decide on whether to pay a dividend or not (with no reference to the size of the payment). Consistent with Baker and Wurgler (2004), there would only be two groups exposed to the dividend policy: nonpayers and payers. The inherent problem with this approach is that it provides a thorough explanation for omitting or initiating certain dividends, but it practically ignores the question of why dividend levels could be altered by organizations (Baker and Wurgler, 2004). It can be considered a problem due to the existence of numerous scenarios where managers are supposed to alter dividend levels and not introduce or eliminate dividends in general.
Another concern that has to be covered when discussing Baker and Wurgler’s (2004) article is the validity of empirical findings obtained by the researchers. One of the key claims that they made was that the dividend premium could lead to an increase upon dividend initiation while also affecting stock returns. In other words, if the demand for dividends was reasonably high among investors, the latter could be expected to generate a positive response to dividend initiations (Baker and Wurgler, 2004). Nevertheless, the article does not present any statistically significant findings that could validate the link between the dividend premium and dividend announcement returns. This is why it could be safe to preserve a reasonable doubt when advocating for the empirical validity of the catering theory. It would be rather unlikely for managers to care about premiums if the capital market ignored dividend premiums unless a dividend initiation announcement was released (Baker and Wurgler, 2004). Hence, the dividend catering model could be seen as a negative phenomenon unless it created enough room for dividend decisions that could reward managers for eventually considering the capital market demand.
Overall, it should be noted that the existing dividends tend to fluctuate much more often than they get initiated or omitted. Therefore, the relevance of the catering theory could be reinforced through the interface of monitoring changes in the present dividends and holding back some of the predictions. According to Baker and Wurgler (2004), dividends have been increasing since the 1960s, which is an important hint at the fact that the catering theory should be extended in order to render Baker and Wurgler’s (2004) findings valid. A continuous dividend level, for example, might become one of the most effective solutions due to many financial organizations taking steps to increase their dividends when exposed to high dividend premiums. Accordingly, the stock price could react in a similar fashion, leading to dividend increases. On a long-term scale, the results presented by Baker and Wurgler (2004) suggest that fluctuating investor demand could inflate the stock price and affect the majority of dividend decisions.
A thorough analysis of the article written by Baker and Wurgler (2004) shows that dividend demand can never be ignored by managers because they would be instantly punished by significantly lower stock prices. The core variable that has to be included in the discussion here is the dividend increase/decrease frequency. It can be concluded that the catering theory could have serious implications for dividend catering and premiums. When organizations choose to diversify their dividends, there are too many internal and external aspects that could influence the decision-making process. Due to these dynamic conditions, it is crucial to treat the catering theory slightly differently and predict negative stock market reactions through the interface of non-catering factors instead. In other words, the idea would be to go beyond the capital market environment when establishing a new dividend policy.
Baker and Wurgler’s (2004) Contribution to the Existing Literature
The central finding of Baker and Wurgler’s (2004) research is a rather close link between catering incentives and the inclination to dividend payments. Therefore, every trend that emerges in the field must be analyzed carefully to define corresponding fluctuations and measure them via the dividend premium variable (Baker and Wurgler, 2004). The propensity to pay dividends cannot be left unnoticed because it mediates catering incentives on all levels, especially in organizations where demand is sentiment-driven. Even if there are limits to the validity of the analysis completed by Baker and Wurgler (2004), it can be claimed that the demand for payers cannot be ignored, especially when the sentiment for extreme-growth stocks is high. The catering theory would help managers avoid the pitfalls of growth stocks crashing and causing the dividend premiums to rise, accompanied by a boosted propensity to pay.
The Phenomena in Financial Markets and Their Connection to the Catering Theory
One of the potentially impactful phenomena that could be associated with the catering theory is the effect of returnee managers on organizational performance. For instance, Kong and Xin (2019) suggested that foreign experiences could have a crucial impact on how the company communicates with its principal customers. In line with the catering theory, returning managers would be much more effective in terms of attracting more consumers and increasing sales. With the aid of returnee managers, companies could engage in international mergers and acquisitions more often (Kong and Xin, 2019). When following the principles of the catering theory, returnee managers would replicate the overseas experience and apply it to their domestic environment in order to diversify and innovate. According to Kong and Xin (2019), experienced returnees could boost the company’s financial state of affairs and facilitate innovation.
Another significant area of discussion that relates directly to the catering theory is the contribution of minority shareholder participation in the process of corporate governance. Kong and Xin (2019) suggested that minority shareholder participation could be associated with a particular stock market (the researchers chose China) and voting data sets. Since the investigators were interested in finding out propensity scores and how they matched against each other, they introduced numerous instrumental variables and estimations to see how earnings management could relate to minority shareholder participation. The catering theory was utilized by Kong and Xin (2019) to demonstrate how managerial incentives and earnings allocation could be mediated by minority shareholder participation. Thus, the catering theory was required to predict required behaviors and collect enough empirical evidence to help government regulators decide on whether they should let minority shareholders control corporate decisions.
The ultimate phenomenon that was discussed in the research article written by Kong and Xin (2019) was the connection between research and development investments and equity market valuation, with both being accompanied by government interventions. The catering theory could be applied to this phenomenon in the case where the rate of market valuation is rather high (Kong and Xin, 2019). In other words, the government should not be expected to impact research and development investments, hence the potentially negative impact of government-led interventions on market mechanisms. Corporate research and development efforts have to be delimited by the functional borders of the government and related markets in order to remain in line with the catering theory as well. Kong and Xin (2019) suggested that resource allocation would be the cornerstone of research and development investments and market valuation intended to spark innovation.
Reference List
Baker, M. and Wurgler, J. (2004) ‘Appearing and disappearing dividends: the link to catering incentives’, Journal of Financial Economics, 73, 271-288. Web.
Kong, D. and Xin, Q. (2019) ‘Corporate finance in China’, China Finance Review International, 9(1), 2-4. Web.
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