Signaling Theory

Because managers know more about their company than outside investors, they may try to signal confidence in ways that are costly or risky to fake.

For example, raising the dividend can signal that managers expect strong, stable future earnings, since cutting a dividend later is usually painful and damages credibility. Buying back shares can signal that managers believe the shares are undervalued. Taking on debt can signal confidence that future cash flows will cover interest payments.

Conversely, issuing new shares may signal that managers think the shares are overpriced, which is one reason share prices often fall when new equity is announced.

For a signal to be believable, it needs to be costly for a weak company to imitate. Signals are not always reliable, because managers may be overconfident or may try to mislead. The theory has roots in economist Michael Spence's work on signals in job markets, and it is widely used to explain dividend policy and market reactions to corporate announcements.