DIVIDEND SIGNALING

A theory that suggests company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. The rationale behind dividend signaling models stems from game theory. A manager who has good investment opportunities is more likely to "signal" than one who doesn't because it is in his or her best interest to do so.

Over the years the concept that dividend signaling can predict positive future performance has been a hotly contested subject. Many studies have been done to see if the markets reaction to a "signal" is significant enough to support this theory. For the most part, the tests have shown that dividend signaling does occur when companies either increase or decrease the amount of dividends they will be paying out.

The theory of dividend signaling is also a key concept used by proponents of inefficient markets.