Main reasons for share repurchases

Main reasons for share repurchases

Temporary market undervaluation often induces corporate incumbents to initiate a share repurchase program to boost the firm's stock price (Lakonishok and Vermaelen, JF 1990; Ikenberry, Lakonishok, and Vermaelen, JF 1995; Nohel and Tarhan, JFE 1998; Rau and Vermaelen, JFE 1998; Peyer and Vermaelen, RFS 2009; Dittmar and Field, JFE 2015). Firms often tend to engage in deliberate net income inflation in the pre-IPO or pre-SEO period to receive favorable corporate income results in the IPO or SEO year (Teoh, Welch, and Wong, JF 1998, JFE 1998). Moreover, firms choose to engage in deliberate net income deflation in the pre-share-repurchase year to receive favorable corporate income results in the post-repurchase period (Gong, Louis, and Sun, JF 2008). Share buyback can serve as a firm's response to temporary market overreaction to bad news such as stock analyst downgrades and pessimistic earnings forecasts (Peyer and Vermaelen, RFS 2009). Corporate incumbents time the stock market by repurchasing shares below the average relative stock price (Dittmar and Field, JFE 2015). Share repurchasers yield significantly positive Fama-French (JFE 1993) multi-factor alphas up to 36 months after the share buyback event.

 

In addition to temporary stock market undervaluation, there are several other reasons for corporate stock buyback. These reasons include:

1. financial flexibility (Chen and Wang, JFE 2012; Bliss, Cheng, and Denis, JFE 2015);
2. dividend-repurchase substitution (Grullon and Michaely, JF 2002; Leary and Michaely, RFS 2011; Michaely and Roberts, RFS 2011);
3. accounting manipulation (Bens, Nagar, Skinner, and Wong, JAE 2003; Gong, Louis, and Sun, JF 2008);
4. systematic risk adjustment (Grullon and Michaely, JF 2004); and
5. peer mimicking behavior (Massa, Rehman, and Vermaelen, JFE 2007; Babenko et al, JFQA 2012).

 

Chen and Wang (JFE 2012) report that financially constrained share repurchasers experience subpar short-term and long-term post-announcement stock return performance. If firms face more severe financial constraints, lower corporate liquidity (as a combination of less cash and higher leverage) from share repurchases can be pernicious. Firms with less financial-constraints risk face greater financial flexibility and can thus afford to repurchase shares even at fair market values. CEO overconfidence in the form of late option exercise or press portrayal explains why financially constrained firms repurchase shares even though this buyback does not add to shareholder wealth maximization. Bliss, Cheng, and Denis (JFE 2015) empirically find that payout reductions in general, and repurchase reductions in particular, serve as a substitute form of corporate finance. Payout reductions are more likely in firms with higher debt ratios, more valuable real growth options, and lower cash balances (i.e. these firms are more vulnerable to substantial external financing shocks). This empirical pattern is more pervasive during tight credit years of the global financial crisis from 2008 to 2009 (Campello, Graham, and Harvey, JFE 2010). Unlike sticky and smooth dividend payments, share repurchases are flexible enough to provide cash proceeds for funding future investment opportunities (Brav, Graham, Harvey, and Michaely, JFE 2005).

 

Grullon and Michaely (JF 2002) propose the dividend-repurchase substitution hypothesis by empirically confirming the negative nexus between share repurchase intensity and excess dividend payout. Nowadays many public corporations have substituted share repurchases for cash dividends as the dominant form of corporate payout. Leary and Michaely (RFS 2011) and Michaely and Roberts (RFS 2011) find evidence in support of the common dividend-smoothing practice among large and profitable firms. Small and unprofitable firms that face risky investment growth opportunities alternatively tend to engage in share repurchases as the dominant substitute form of corporate payout.

 

Bens, Nagar, Skinner, and Wong (JAE 2003) suggest that share buyback helps moderate the impact of employee stock option (ESO) exercise on EPS dilution. Gong, Louis, and Sun (JF 2008) empirically find that firms engage in deliberate earnings deflation around share repurchase announcements for better post-announcement stock return and operating performance. These manipulative accounting practices such as deliberate EPS concentration and net income management serve as an alternative motivation for share buyback.

 

Grullon and Michaely (JF 2004) suggest that most share repurchases precede a decline in systematic risk or cost of capital but not an improvement in operating performance. The stock market underreacts to this decline in systematic risk or cost of capital due to gradual news diffusion (Hong and Stein, JF 1999; Hong, Lim, and Stein, JF 2000; Hong, Torous, and Valkanov, JFE 2007). The information content of share repurchases need not reflect any material change in the firm's relative stock market valuation but its systematic risk profile.

 

Massa, Rehman, and Vermaelen (JFE 2007) point out that share buyback sends a positive signal about the firm's financial capacity while this buyback sends a negative signal about the financial capacity of the firm's rivals in the same industry. In this light, many firms mimic the share repurchase decisions of rivals in the same industry. Babenko et al (JFQA 2012) empirically find that insider share purchases help strengthen the credibility of the firm's share repurchases prior to the stock market's more favorable reaction.

 

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