Signaling theory is a concept where one party, known as the agent conveys information in a credible manner about itself to another party known as the principal. The original concept of signaling theory was initially developed by Michael Spence and published in the Quarterly Journal of Economics in a paper entitled Job Market Signaling. The theory was based on observed knowledge gaps between organizations and prospective employees. The intuitive nature of the theory led to adaptations and applications in numerous other domains, such as Human Resource Management, business, and in particular financial markets.
Although in the financial arena the theory is commonly associated with dividend policy, the common sense approach can adapt the theory to any corporate action and in particular those actions taken by management. A concept related to dividend payments, an act of returning cash to shareholders, is the share repurchase program. Buying back company stock removes share capital from the market place. The idea is that the cash was sitting on the books of the firm not generating investment returns. The company can choose to pay a special dividend or repurchase its own shares. Upon announcing the intention to buyback a certain quantity of stock, the stock price of the firm increases. This produces an increased capital gain for the stockholders who can then choose whether or not they wish to sell their stock.
Signaling Theory in Practice
The theory states that management of the firm, who have detailed inside knowledge of current investments and prospects would not be buying back the stock if they consider the price to be high. It is at this point the common sense approach to applying the theory begins in earnest. For example, management of Red Robin Gourmet Burgers (RRGB) announced a share repurchase program as a defense mechanism in response to a hostile bid from Vintage Capital. As this was a reactive, rather than proactive action, the conclusion will be different. Management may not necessarily believe their stock price is too low, they may be just saying that to thwart the hostile takeover bid.
The biggest criticism of Signaling theory however is the accuracy of judgement, or faith, the observer places in management to make the right decision. Company managers and the board of directors are not investment analysts. They may not be in the best place to call whether the company stock price is “low” or “high”. The opposite of this scenario is the acquisition of another company using the firm’s own stock when the price is perceived to be “high”. The efficient market hypothesis suggests investor will be no better or worse off in the long run regardless of the timing of decisions by management.
