What better way to send a message than a stack of cash? Income seeking investors are well aware of the link between dividends and profits. A highly profitable blue chip company in a mature industry is more likely to pay out a hefty dividend to long term shareholders. However, investors often forget that the dividend policy itself could be a way to judge the company’s future prospects.

Of course, dividends are frequently used to value stocks. Dividend discount and Gordon growth methods are some of the most popular valuation techniques on Wall Street. Nonetheless, these techniques require a degree of estimation. Investors need to be able to accurately predict the company’s future earnings potential in order to get a truly fair value for the stock.

Signaling theory suggests the dividend policy could help with this. According to ‘signaling theory’ dividends could, in most cases, serve as a window into the minds of the company’s managers.

Here’s what you need to know:

Dividends are sticky

Dividend policies are long term commitments. Professional investors and income seekers pay close attention to the yield, coverage, and sustainability of the annual dividend. Some investors live off these investments, so a minor change in policy could have an outsized impact on their finances.

Managers realize the gravity of these policies, are are reluctant to declare a policy change  they can’t sustain. In effect, dividends are really sticky and changes are somewhat rare. It’s in everyone’s interest to keep the policy as stable as possible.

Policies are signals

A shift in dividend policy is a long term commitment. So, an increase in payout or dividend amount is not just a sign of a profitable year, it’s a sign the management has confidence in the firm’s earning potential for the foreseeable future.

Multiple empirical studies have established a link between increased dividends and future earnings performance. There’s evidence to suggest the market reaction to a dividend increase is generally positive, and managers utilize this effect to draw attention to the underlying value in their company.

Signals work both ways

If dividend increases and special dividends can signal a bright future, a sudden cut in dividends could signal economic decline. Weakening prospects and a declining balance sheet are usually enough to make managers cut the dividend. Energy companies cut dividends when the price of oil declined in the past few years, while several companies have announced dividend cuts when they struggled to pay their debt. Dividend cuts hit a record high during the financial crisis of 2008-2009.

Again, dividend policy was the canary in the coal mine. Cuts signaled difficult times and financial stress.

Final Thoughts

Besides special dividends, most dividend policies are long-term commitments. Managers are aware of the fact that investors are keenly focused on dividend policies and relative yield. So, a sudden uptick in dividends is a clear sign that the management is confident about the company’s future prospects.

Studies suggest there is a clear link between rising dividends and overall stock performance. Meanwhile, dividend cuts could indicate weakening financials and a pessimistic economic outlook.

For better performance, income-seeking investors should pay close attention to these ‘dividend signals’.