Signaling theory explains how signals management success or failure is communicated to the owner. Signal theory related to information asymmetry. The positive thing in signaling theory is where companies that provide good information will set them apart with companies that do not have “good news” by informing to the market about their condition, a signal of good future performance the future provided by companies whose past financial performance is not good will not be trusted by the market (Wolk and Tearney in Dwiyanti, 2010).
Signaling theory is one of the pillar theories in understanding financial management. In general, the signal is interpreted as a signal made by the company (manager) to outside parties (investors). These signals can take the form of various forms, both those that can be directly observed, or which must be studied more deeply to be able to find out. Regardless of the form or type of signals issued, they are all intended to imply something in the hope that the market or external parties will make a change in the valuation of the company. That is, the selected signal must contain the power of information (information content) to be able to change the assessment of the company’s external parties.
The relationship between signal theory and the company’s financial performance is The wider disclosure will give a positive signal to the parties interested in the company (stakeholders) as well as the stakeholders shareholders of the company (shareholders). The wider the information conveyed to stakeholders and shareholders, it will be more reproduce the information received about the company. This will generate stakeholder and shareholder trust in the company. This trust is shown by stakeholders by receiving products company so that it will increase profits and Return on Equity (ROE) company.
In economics and finance literature, signal theory is intended to explicitly reveal evidence that parties within the company (corporate insiders, consisting of officers and directors) generally have better information about the company’s condition and future prospects than outsiders. , for example investors, creditors, or the government, even shareholders. In other words, the company has the advantage of mastering information than outsiders who have an interest in the company. The condition in which one party has an excess of information while the other party does not in financial theory is called information asymmetry.
In contrast, signaling theory focuses mainly on actions insiders take to intentionally com-municate positive, imperceptible qualities of the insider. Insiders could potentially inundate outsiders with observable actions, but not all of these actions are useful as signals. There are, however, two chief characteristics of efficacious signals. The first is signal observability, which refers to the extent to which outsiders are able to notice the signal. If actions insiders take are not readily observed by outsiders, it is difficult to use those actions to communicate with receivers.
Why Are Signals Important?
The relationship between signal theory and firm value is CSR disclosure carried out by the company will further expand disclosure in annual report. This is a positive signal given by the company to investors. The wider the disclosure made by the company will add to the information received by investors. The wider the information received by investors will increase the level of investor confidence in the company. With a high level of confidence, investors will certainly provide a positive response to the company in the form of price movements stocks that tend to rise. Thus, the level of disclosure that carried out by the company will affect the movement of stock prices tends to rise which in turn will also affect the volume of traded. With stock price movements that tend to increase will certainly affect the increase in the company’s stock return.
Akerlof (1970) presents a simple but meaningful illustration of the importance of signals to distinguish the good qualities of a company from those of other companies. Companies that are indeed better in quality are required to be creative and dare to use certain signals that imply that they are indeed good and cannot be equated with other companies that are not good. One method that can be done by managers is to apply a signal (signal) which can be quite expensive and can still be done (affordable), by their company, but will be very difficult to do or be imitated by low-quality companies because it is too expensive for the company. One of the most effective and useful methods is the provision of large dividends (high dividend pay-out).
- Connelly, B. L., Certo, S. T., Ireland, R. D., & Reutzel, C. R. (2011). Signaling theory: A review and assessment. Journal of management, 37(1), 39-67
- BliegeBird, R., & Smith, E. (2005). Signaling theory, strategic interaction, and symbolic capital. Current anthropology, 46(2), 221-248.
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