Signaling Theory

Overview

Signaling theory (Spence, 1973) explains how informed parties credibly communicate private information to uninformed parties through costly actions. In finance, firms signal quality through dividends, capital structure, underpricing, and other mechanisms that are too costly for low-quality firms to mimic.

When to Use

• Analyzing why firms pay dividends despite tax disadvantage
• Evaluating IPO underpricing as a quality signal
• Assessing whether a corporate action conveys credible private information
• Designing mechanisms to separate high-quality from low-quality issuers

When NOT to Use

• When information asymmetry is minimal (both sides have equal information)
• For cheap-talk communication (costless signals are not credible)
• When the signaling cost exceeds the benefit to the signaler