Informational content of dividends

Meaning. The informational content of a dividend is the information a dividend payment conveys to investors about the firm's profitability and prospects, which they cannot observe directly. The relevance school (Walter, Gordon and others) holds that dividends communicate information to investors about the firm's profitability, which is why the dividend decision affects the value of the firm.

Why a dividend carries information. Managers set dividends on a long-term view of sustainable earnings, are more concerned with changes in the dividend than with its level, and raise it only when earnings have risen to a lasting higher level. A dividend decision therefore reveals management's own expectation of future earnings.

How it affects the value of the share

1. Dividend increase: read as a signal that management expects higher earnings to last, so investors revise their expectations upward and the share price rises.
2. Dividend cut or omission: read as a signal of lower future earnings, so the share price tends to fall.
3. Stable dividend: a regular, steady dividend signals confidence in sustainable earnings; firms paying higher dividends are valued more highly than those that pay none or pay less.

Implications. Firms avoid frequent changes in dividends and prefer a stable policy, so as not to send unintended signals. The irrelevance theorists (MM) accept that share prices react to dividend announcements, but attribute the reaction to the information conveyed, not to the dividend itself.