The Information Content of Dividends

Abstract

The seminal contribution to research on dividend policy is Miller and Modigliani (1961). They show that with complete and perfect capital markets and no taxes, a firm’s dividend policy will not affect its value. The basic premise of their argument is that firm value is determined by choosing optimal investments. The firm net payout, defined as the difference between earnings and investments, is simply a residual. Since the net payout consists of dividends and shares issues/repurchases, a firm can always adjust its dividends to any level with an offsetting change in shares outstanding. Financing an increased dividend by issuing new equity or decreasing dividends by repurchasing equity merely involves a transfer of ownership, the underlying cash flow to securityholders is unchanged and so the value of the firm is unchanged. Dividend policy is also irrelevant for investors, because any desired stream of payments can be replicated by appropriate purchases and sales of equity. However, if dividend policy is essentially an exercise of financial packaging, if dividends are simply a financial detail, why are announcements of dividend increases typically followed by stock price increases, sometimes spectacularly so? Why are dividend cuts or elimination often followed by price falls, sometimes even more spectacular?¹