What is Debt Signaling
Debt signaling is a theory that correlates a stock's future performance with any announcements made regarding its debt. Announcements typically made about a company taking debt are seen as positive news.
BREAKING DOWN Debt Signaling
In the world of finances and economics, investors are always seeking opportunities. They usually determine these by signals they receive from corporations. Sometimes those signals come from the company’s management team, but they can also come from actions made by the company, including when the company says it will take on more debt. These are referred to as debt signals. There are both positive and negative debt signals, both of which can have a big impact on the way a company's stock performs.
Debt Signaling vs. Other Financial Signals
Companies can raise capital in different ways: internally, through debt and through equity. The first is usually internally, meaning directly from the company and its profits. However, if that isn’t feasible, a company will turn to debt, a much preferred method of financing over raising equity, since the cost of equity is usually higher than debt. Equity is also a means of diluting ownership of a company.
Positive Debt Signals
The type of financing can signal the future of the company’s financial position and any prospects for projects the company may have. When a company announces that it will take on more debt (typically for a new project), that signals sound financial health to investors and to the market, making it a positive debt signal. So when a company wants to take on more debt, that means it is committed to paying interest on it. The company also indicates that it believes strongly in its project (and therefore, its financial health) and believes that it will provide quick returns — enough to pay down the debt and to provide (financial) benefit to its investors.
Negative Debt Signals
If, on the other hand, any future debt is reduced, investors may see this as a sign that the company is unable to make its interest payments and is in a weak financial situation. Similarly, if the company chooses to raise new equity rather than take on any debt, this is a negative debt signal. This means that a company does not have enough confidence in its financial situation or its projects, does not have enough profits, or just cannot raise enough debt.
Debt Signaling Example
In October 2017, online streaming and content producer Netflix announced it was going to raise about $1.6 billion in debt. The company said it would use the funds for general purposes including funding for new content. This was seen as a positive step for the company, and therefore as a positive debt signal. Investors were seemingly pleased by the news, as the company's stock increased immediately following the announcement.