The nature of dividends may appeal to investors because they offer consistent returns on relatively low risk investments. While companies experiencing rapid growth are unlikely to offer dividends, established companies with stable business and less room to grow do pay dividends to shareholders. Despite the low earnings growth of these stocks, shareholders get the benefit of knowing that the value of their initial investment is likely to remain stable. They can still profit off a steady stream of dividend payments.
A firm's dividend decision may also serve as a signaling device which gives clues about a firm's future prospects. Due to information asymmetry between investors and the firm managers, investors will look to indicators like dividend decisions. Studies have shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm's ability to generate cash flows in the future they may keep dividends constant or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm are more likely to increase dividends.
Investors can use this knowledge about managers' behavior to determine their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. Managers tend to avoid sending a negative signal to the market about the future prospects of their firm. This also tends to lead to a dividend policy of a steady, gradually increasing payment .
Stock prices shown in a ticker in Tokyo, Japan
Stock prices may be informed by a firm's dividend decisions.
On the other hand, critics of dividends contend that company profits are best re-invested back into the company for research and development, capital expansion, and so forth. Their view is that an eagerness to return profits to shareholders may signal to investors that the management does not have ideas for the firm's future prospects.