The Information Content of Dividends and Repurchases

A survey in 2004 asked senior executives about their companies’ dividend policies. Figure 16.3 paraphrases their responses. Three themes stand out:

1. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would issue shares or borrow to maintain the dividend.
2. Managers “smooth” dividends. Dividend changes follow shifts in long-run, sustainable earnings. Transitory earnings changes are unlikely to affect dividends.
3. Managers focus more on dividend changes than on absolute dividend levels. Thus paying a dividend of $2.00 per share is an important financial decision if last year’s dividend was $1.50, but no big deal if last year’s dividend was also $2.00.

From these responses, you can see why announcement of a dividend increase is good news to investors. Investors know that managers are reluctant to reduce dividends and will not increase dividends unless they are confident that the payment can be maintained. Therefore announcement of a higher dividend signals managers’ confidence in future profits. That is why investors and financial managers refer to the information content of dividends.

The information content of dividends implies that dividend increases predict future profit­ability. Evidence on this point is somewhat elusive. But Healy and Palepu, who focus on com­panies that paid a dividend for the first time, find that, on average, earnings jumped 43% in the year a dividend was paid. If managers thought that this was a temporary windfall, they might have been cautious about committing themselves to paying out cash. But it looks as if these managers had good reason to be confident about prospects, for earnings continued to rise in the following years.^[3] On the other hand, it appears that dividend increases by companies already paying regular dividends do not predict increases in future earnings. Instead the increases pre­dict safer earnings. Managers are more likely to increase dividends when they expect future earnings and cash flow to be less volatile and uncertain than usual. They are less likely to increase dividends, and more likely to cut dividends, when they see unusual risks ahead.^[4]

Investors certainly appear to take comfort from an increase in dividends. It is no surprise, therefore, to find that a higher dividend prompts a rise in the stock price, whereas a dividend cut results in a fall in price. For example, in the case of the dividend initiations studied by Healy and Palepu, the dividend announcement resulted in a 4% stock-price increase on average.^[5]

Notice that investors do not get excited about the level of a company’s dividend; they worry about the change, which they view as an important indicator of the sustainability of earnings.

Do not assume that all dividend cuts are bad news, however. The nearby box explains how investors endorsed a drastic dividend cut announced in 2009 by JPMorgan Chase.

1. The Information Content of Share Repurchases

Announcement of a share repurchase is not a commitment to continue repurchases in later years. So the information content of a repurchase announcement is less strongly positive than the announcement of a dividend increase. Nevertheless, a study by Comment and Jarrell, who looked at the announcements of open-market repurchase programs, found that, on average, they resulted in an abnormal price rise of 2%.⁹

Investors may applaud repurchases if they worry that managers would otherwise fritter away the money on perks or unprofitable empire building. Stock repurchases may also be used to sig­nal a manager’s confidence in the future. Suppose that you, the manager, believe that your stock is substantially undervalued. You announce that the company is prepared to buy back a fifth of its stock at a price that is 20% above the current market price. But (you say) you are certainly not going to sell any of your own stock at that price. Investors jump to the obvious conclusion— you must believe that the stock is a good value even at 20% above the current price.

When companies offer to repurchase their stock at a premium, senior management and directors usually commit to hold on to their stock.¹⁰ So it is not surprising that researchers have found that announcements of offers to buy back shares above the market price have prompted a larger rise in the stock price, averaging about 11%.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.