4. Information Content and Signaling

We have already seen that dividends are rather sticky:

  • Firms try to avoid cutting dividends
  • Firms will tend to increase dividends only if they believe that they can afford the higher dividend payment for the foreseeable future.

 

Hence, higher dividends signal to the market that the firm is expecting to do well in the future. Because of the stickiness of the dividend policy discussed above, this signal also seems to be rather credible.

 

Firms could therefore use this exact same signal to inform the market that it is optimistic about the future (information content effect). Signaling financial health could be particularly valuable at times where the market is uncertain about the business prospects.

 

As we have discussed before, the announcement of a large share buyback could send the opposite signal to the market, namely that the firm has run out of valuable investment opportunities.