Since Finance, basically, is the management of assets and liabilities over a specific period of time under certain conditions; how best to present this aspect of a business for the purpose of inspiring investor confidence becomes the essential task of a manager. Signalling is a very important idea where one agent conveys some information about itself to another party through an action. It grew from the notion of asymmetric information; in this case, managers know more than investors, so investors will tend to find “signals” in the managers’ actions to get clues about the firm.
What asymmetric information assumes is that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services. Therefore, the information asymmetry that exists between firm managers who know more about the firm and its future prospects than the investors creates this precarious relationship between the two agents, which determines the ultimate survivability of the firm. Consequently, it is of utmost importance that management sends the right signals so investors can pick up favourable cues for their final decision.
In cases where investors have incomplete information about the firm, (perhaps where opaque accounting practices abound) they will look for other information in actions such as the firm’s dividend policy. For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or probably even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.
Investors utilize this knowledge about managers’ behaviour to educate 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. As 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, for example.
The appetite for yield is what drives investor confidence. If managers cannot give a promising yield capacity for the firm, then that has an undesirable effect on investors, the converse being equally true. But, at the end of the day, the most important thing for the manager is to find balance in regards to giving the right signals and managing investor expectation such that they give an accurate depiction of the state of affairs.