Signaling Theory

Signaling Theory
1. History and Background
 Signaling theory is the belief that information on a company's
financial health is not available to all parties in a market at the same
time
 Signaling refers to the act of using insider information to initiate a
trading position. It occurs when an insider (Manager) releases
crucial information about a company that triggers the buying or
selling of its stock by people (Shareholders) who do not ordinarily
possess insider information. The actions of the insider are
considered a market signal to outsiders.
 Signaling Theory
2- Example of the Signaling Theory
 According to dividend signaling theory, when a company announces
that dividend payments are going to increase, investors and analysts
pick this up as a strong market signal that the business’ prospects are
good.
 If John Doe Inc. announces an increased dividend payout, this
information is taken positively in the market and helps build a
favorable image of the firm regarding its future economic health and
growth prospects.
 If a company’s share value goes up after it announced a greater
dividend payout, that rise is due to dividend signaling.
 Signaling Theory
3- Main Assumptions
I. information asymmetry = information is not equally available to all
parties (specially the shareholders) at the same time.
II. Firms’ managers (insiders) know more about the quality of their firms
than outside investors.
III. Insider trading may exist
I. Either manager purchase/sell own shares or recommend his friends to
sell/purchase shares