Understanding Information Content of Dividends & Clientele Effect

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  • 0:00 What Are Dividends?
  • 1:01 Information Content Theory
  • 2:15 The Clientele Effect
  • 4:25 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

What does the dividend level say about the company giving out the dividend? And should companies set their dividend levels to try to please their shareholders? In this lesson, we'll explore two theories about dividends: the information content theory and clientele effect.

What Are Dividends?

Sarah is the CEO of a publicly owned company. That is, her company is for sale on the stock market, and anyone can buy shares. One goal of Sarah's company, like all publicly owned companies, is to attract more investors to buy shares of the company. Sarah wonders how she can do this. One way to entice people to buy shares of a company is to offer dividends, or payments to stockholders, from the company's income. Dividends could be paid in cash, more stock, or a number of other ways. The most common type of dividend is a cash dividend.

Sarah thinks that her company should pay out a dividend to their shareholders to help entice people to invest. But she's not sure about whether it's better to pay a low or high dividend. Does it matter how much of a dividend she offers? To answer that question, let's take a look at the information content of dividends and the clientele effect and what they say about how to set the price of dividends.

Information Content Theory

As we've seen, Sarah wants to know whether her company should distribute a high dividend or a low dividend to their stockholders. The information content of dividends theory says that a high dividend indicates that the company is strong and a good investment. The idea is that if a company pays out a high dividend, it is because it is financially sound and will earn a lot in the future. Intuitively, Sarah can see where the information content of dividends theory comes from. After all, if her company makes $1 million, their dividends are likely to be lower than if the company makes $100 million.

But there's a problem with this theory. Namely, companies know that many people see dividend levels as indicative of future earnings and that high dividends can attract more investors, thus driving up the stock price and bringing in more money. Because of that, some companies can set a higher dividend level just to try to make people believe that the company is doing well and entice investors to buy. Whether the information content of a dividend payout is an accurate reflection of how a company is doing and how it will do in the future or not, though, the market usually responds to dividend levels as though they provide valuable information.

The Clientele Effect

Based on how people are more likely to buy a company's stock if their dividend is high, Sarah thinks that her company should provide a high dividend to the stockholders. But is it always best to provide high cash dividends? Some companies choose to provide lower cash dividends in order to attract a specific type of investor. Because investors differ in their needs and in their tax brackets, some prefer high cash dividends, and others actually prefer low cash dividends.

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