Company dividend policies and decisions have been studied extensively and there are various theories explaining how management decides what, if anything, to pay out to shareholders. Factors influencing the dividend decision include the stability of earnings, dividend policy of competing firms, past dividend rates and the information signaling effect. We will consider the latter here.

There are also various types of dividends, such as cash, scrip, debenture and bond, which are beyond the scope of this article.

SEE: How Dividends Work For Investors

The Logic of Information Signaling
Managers take dividend decisions seriously. After all, who doles out money without thinking? Accordingly, how much is paid out should tell us something about the company, such as how it is doing now and how the directors think it will do in the future. In other words, quite apart from the money itself, dividends arguably serve a partially independent signaling and informational function.

Companies and their accounting practices are often not particularly transparent, so investors are keen to find out what they can from all available sources. Therefore, analysts and active investors watch for news on dividends and for their part, directors and managers are surely aware that apart from rewarding shareholders, they are also transmitting a signal.

SEE: Dividend Facts You May Not Know

What the Research Tells Us
A seminal study by Merton Miller and Kevin Rock in 1985 stressed that dividend announcements reveal something about the future prospects of a company. Dividends can signal managerial perceptions of the condition of a firm and, in particular, how management thinks company earnings will develop over time. Indeed, earlier work had pointed to rises and falls in stock process in tandem with dividend announcements.

A 2006 article by Michelle Hanlon et al. confirms the value of dividends in conveying relevant information on future earnings. This information is also reflected in stock prices. Naturally, the size of the dividend is also significant, and not just the fact that there is one at all. Dividends vary from minimal to so high that the stock can be worth owning for this reason alone. In the simplest sense, dividend cuts are interpreted as bad news and vice versa. However, the reality is of course not quite so simple.

The Limits of the Research and of the Signaling Function
The research can be quite complex and there is a fair amount of inconsistency and contradiction in the literature. The methodology behind the research is not straightforward and is affected, for instance, by whether "loss firm-years" are included in the sample of companies investigated.

There can also be important differences between industries and sectors, both with respect to theory and practice. For example, one researcher demonstrated that dividend decisions made by commercial banks are quite different than those made by, say, manufacturing companies. The point is that commercial banks are monitored by a central one to ensure that capital reserves, loan loss reserves and so on, are all in order. Clearly, such regulation is reflected in dividend decisions.

SEE: Is Your Bank On Its Way Down?

Furthermore, it is not just the earnings position of the firm that matters, but the economic efficiency that underlies the earnings. There is empirical evidence to suggest a positive relationship between efficiency and dividend levels. Accordingly, earnings now and in the future may diverge quite substantially. A dividend may, thus, signal something about the present and/or the future and it is not always easy to tell the difference.

The conventional theory is that dividend changes should be followed by changes in profitability in the same direction. However, some major studies have found that this appealing logic does not apply with any certainty. What seems more likely, therefore, is that dividend changes are merely associated with changes in risk and future earnings growth or profitability, but one cannot rely on a clear, ambivalent signaling function in a specific direction.

This may be disappointing, but, after all, sure things in the field of investment are rare. Mostly, there are indications, tendencies and trends. The markets really aren't perfect.

However, There Is Still News You Can Use
However, the trend can be your friend and so can the dividend signals. A study published in 2005 from Brav et al. surveyed financial executives and found that two thirds regard earnings stability as an important factor influencing investment decisions.

In the same year, Caskey and Hamilton found that firms accused by the SEC of financial accounting fraud paid generous dividends when actually committing the fraud, but less and less often generally. Therefore, there were some signals there all right, but they were not very easy to interpret up front.

SEE: Detecting Financial Statement Fraud

The lesson for investors is that dividend decisions certainly transmit information and signals above and beyond the mere fact that money will be paid to shareholders. However, the information needs to be interpreted with caution and in context. It is also important for investors to use information from other sources in combination with that conveyed by dividends.

The Bottom Line
The exact information value of dividends remains something of an open issue. The mechanisms at work and the conversion mechanisms of financial and economic realities into dividend policies and decisions are complex and neither fully researched nor completely transparent. All the same, this is undoubtedly a factor that analysts and investors should observe. However, they also need to observe the ongoing controversy on the subject. As the saying goes, "watch this space."

Related Articles
  1. Mutual Funds & ETFs

    The 3 Best American Funds for the Income Seeker in 2016

    Learn about American Funds' mutual fund offerings, their past performance compared to peers and three American funds to consider for income investors.
  2. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  3. Investing Basics

    How And Why Do Companies Pay Dividends?

    The arguments for dividends include the idea that a dividend provides certainty about a company’s well being.
  4. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  5. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  6. Investing Basics

    The Top 4 Income Investments for Retirees in 2016

    These four investment types should mitigate risk in 2016 for retirees seeking income.
  7. Mutual Funds & ETFs

    The 5 Best T. Rowe Price Funds for the Income Seeker in 2016 (TROW)

    Find out which T. Rowe Price mutual funds to use to create a diversified income portfolio for current income, income growth and capital preservation.
  8. Stock Analysis

    4 Energy Stocks for Income Seekers in 2016 (COP, CVX)

    Discover four energy companies that could maintain or even increase their dividends in 2016, making them the best investments for income-seeking investors.
  9. Mutual Funds & ETFs

    The 4 Best Fidelity Funds for Income Seekers in 2016

    Discover the four best fixed-income mutual funds administered and managed by Fidelity Investments suitable for income-seeking investors.
  10. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  1. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  2. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  3. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  4. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  5. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
  6. What is the formula for calculating earnings per share (EPS)?

    Earnings per share (EPS) is the portion of a company’s profit that is allocated to each outstanding share of common stock, ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center