Option-Based Compensation,Corporate Investment Policy,and Stock Repurchases

Abstract:

Taking account of the business life cycle, this paper investigates the impact of the proceeds associated with stock option exercises on investment expenditures and stock repurchases. The results reveal that the proceeds associated with option exercises could add internal funds to firms and contribute to investment in research and development and capital expenditures, especially in the growth stage of a firm’s life cycle. This paper also shows the positive relationship between option proceeds and stock repurchases in the stagnant stage of that cycle. The empirical results further suggest that stock repurchases may substitute for dividends. In summary, the paper empirically demonstrates that stock options not only encourage employees to work harder, but also create more funds for the firm.     

Executive incentives and payout policy: Empirical evidence from Europe

We investigate how corporate payout policy is influenced by executive incentives, i.e. stock and option holdings, stock option deltas and stock-based pay-performance sensitivity for 1,650 publicly listed firms from the UK, Germany, France, Italy, the Netherlands and Spain, over the period from 2002 to 2009. Our results show that executive stock option holdings and stock option deltas are associated with lower dividend payments in our sample of European countries, where we do not observe any presence of dividend protection for executive stock options. We find that this relationship is mainly driven by exercisable stock options and by options that are in the money. Additionally, we observe that executive stock option holdings and stock option deltas have a negative impact on total payout, suggesting that executives do not substitute share repurchases for dividends. Furthermore, the fraction of share repurchases in total payout increases as executive stock option holdings and stock option deltas increase. Finally, our results show that executive share ownership and stock-based pay-performance sensitivity may mitigate agency conflicts by significantly increasing the level of total payout.     

Stock repurchasing and corporate social responsibility

Stock repurchases are controversial. Researchers often view the positive association between free cash flow and the volume of the stock repurchases to be in the shareholders’ interest and the positive association between executive options and stock repurchases to be in the managers’ interest. Using firms’ corporate social responsibility (CSR) ratings as a measure of ethical culture—one that increases the cost of self-serving behavior for managers— we examine whether a firm’s CSR rating is related to its stock repurchase decisions. Although the baseline regression shows a positive association between CSR and repurchases, we find that CSR amplifies the positive association between free cash flow and stock repurchases and lessens the positive association between executive options and stock repurchases. These results indicate that ethical culture might play a role in repurchase decisions: it may encourage repurchases aligned with shareholders’ interests and discourage those primarily in managers’ interest. Furthermore, we also find that high CSR firms are associated with a greater completion rate of announced repurchase programs and receive more favorable stock market reaction to their repurchase announcements.     

Share Repurchases and Pay-Performance Sensitivity of Employee Compensation Contracts

I show that share repurchases increase pay-performance sensitivity of employee compensation and lead to greater employee effort and higher stock prices. Consistent with the model, I find that after repurchases, employees and managers receive fewer stock option and equity grants, and that the market reacts favorably to repurchase announcements when employees have many unvested stock options. Managers are more likely to initiate share repurchases when employees hold a large stake in the firm. Moreover, since employees are forced to bear more risk in firms that repurchase shares, they exercise their stock options earlier and receive higher compensation.     

Does Labor Power Affect the Likelihood of a Share Repurchase?

This research examines the impact of labor power on the firm's repurchase decisions. Firms facing stronger labor power repurchase fewer shares, suggesting that, on average, repurchases are against the interests of labor. However, the negative effect of labor power on repurchases is significantly reduced when repurchases benefit employees by fending off an unwanted takeover or countering the dilution effects of employee stock options. We also examine the ex post consequences of share repurchases. Repurchases are positively related to the probability of a strike. Repurchase announcement returns and the operating performance of repurchasing firms are negatively related to labor power.     

Intangible Assets and Corporate Signaling

Research and development (R&D) and advertising expenditures often result in patents, technologies and brand names which are difficult to accurately value. Under current generally accepted accounting principles (GAAP) these intangible assets are generally not recognized in the financial statements, but instead are expensed in the period that they occur. Prior studies note that the market-to-book ratios of firms with significant levels of R&D and advertising expenditures suggest that investors, at least partially, value these assets. Researchers and practitioners argue that current GAAP, by not recognizing these intangible assets, reduces the usefulness and relevance of accounting reports.We investigate whether companies with significant levels of intangible assets are more likely to emphasize dividend increases and stock repurchases (which are generally perceived as signaling favorable investment opportunities), instead of traditional accounting disclosures, as a means of overcoming adverse selection. Because these assets are difficult to measure, cash distributions may be viewed as a more credible means of signaling firm value to investors. Using analysts' ratings of firms' accounting disclosures, we find that companies with higher levels of R&D and advertising expenditures are less likely to provide extensive accounting disclosures and instead tend to employ dividend and stock repurchase signals. We obtain these results even after controlling for other firm attributes, such as size, stock returns performance, leverage, liquidity and investors' expectations of growth opportunities. We also find that the market reaction to dividend increase and stock repurchase announcements is greater for firms with higher levels of R&D and advertising expenditures, indicating that these announcements are more informative for such firms.     

Stock repurchases as an earnings management device

We investigate whether firms use stock repurchases to meet or beat analysts’ earnings per share (EPS) forecasts. We identify conditions under which repurchases increase EPS and document the frequency of accretive repurchases from 1988 to 2001. We find a disproportionately large number of accretive stock repurchases among firms that would have missed analysts’ forecasts without the repurchase. The repurchase-induced component of earnings surprises appears to be discounted by the market, and this discount is larger when the repurchase seems motivated by EPS management, although using the repurchase to avoid missing analyst forecasts appears to mitigate some of the negative stock price response.     

Cash holdings and share repurchases: International evidence

In this study, we examine the patterns and determinants of share repurchases using firm-level data from seven major countries—Australia, Canada, France, Germany, Japan, the U.K., and the U.S.—over the period 1998–2006. We find that while non-U.S. firms do not repurchase shares as much as U.S. firms do, both U.S. and non-U.S. firms display a common set of share repurchase behaviors. For example, across countries, firms use share repurchases as a flexible means of distributing cash. More importantly, large cash holdings are significantly associated with the amount of share repurchases in all countries. There is evidence that large cash holdings held by repurchasing firms represent excess cash. Firms tend to experience substantial increases in cash holdings prior to share repurchase as a result of reductions in capital expenditures. Overall, our evidence lends support to two hypotheses: (i) firms discharge excess capital to reduce agency conflicts and (ii) firms use repurchases to distribute temporary cash flows.     

Limited attention,share repurchases,and takeover risk

We hypothesize that announcing open market share repurchases (OMRs) to counter negative valuation shocks reveals repurchasing firms’ lost growth opportunities or underperforming assets to potential bidders, making them more likely to become takeover targets. This also leads their investors to face higher takeover risk, a systematic risk associated with economic fundamentals that drive takeover waves, as proposed by Cremers et al. (2009). Indeed, we find that repurchasing firms tend to face higher takeover probability in the first few years following their OMR announcements, and that the increase in takeover risk can largely explain their post-announcement long-run abnormal returns documented in the literature. The increase in takeover risk is larger for smaller firms, firms with poorer pre-announcement stock performance, and those attracting more attention of market participants. Our results suggest that OMRs, which are used by many firms to counter undervaluation, could make the firms more sensitive to takeover waves and raise their cost of equity capital.     

Payout flexibility and capital expenditure

Over the past two decades or so, repurchases have become an appealing method for disbursing cash to shareholders compared to the traditional dividends. Managerial perception as well as empirical evidence suggests that repurchases are inherently more flexible than dividends, which may account for their increasing popularity. The rigidity of dividends and the apparent flexibility of share repurchases could impact firm investments. Firms may forego profitable investment opportunities to maintain their dividend levels, while repurchases could be easily scaled back to fund profitable investment projects without fear of an adverse market reaction. We test the flexibility hypothesis of repurchases by regressing capital expenditures on repurchases and dividends in addition to other control variables. Consistent with our hypotheses, we find an inverse relationship between capital expenditures and repurchases but an insignificant relationship with dividends. Further, we find that the flexibility associated with repurchases is especially evident for firms that are financially constrained, and during the recent financial crisis period when external capital constraints were severe. Finally, we find that flexibility of repurchases with respect to capital expenditures is stronger in the more recent time period during which regulatory changes made repurchases more attractive as a mechanism to disburse cash back to shareholders.     

Dividends and share repurchases during the COVID-19 economic crisis

In this article, we examine dividends and share repurchases of S&P 1500 firms during the COVID-19 crisis characterized by the stock market crash and a relatively quick stock price recovery propelled by technology stocks. We find that the great majority of firms either maintain or increase the level of dividends during the crisis period. Yet, the relation between the dividend payout and reported earnings is negative and significant. This relation also holds for other types of payouts, including share repurchases and special dividends. Moreover, we find that both forecasted and realized earnings of up to 1 year into the future are negatively associated with current dividends, implying that existing payout policies are unsustainable in the longer term. Surprisingly, the difference-in-differences test shows that firms strongly affected by the COVID-19 crisis have higher dividend payouts (relative to net earnings) compared to unaffected firms. The same test indicates that strongly affected firms significantly reduce repurchases.     

The Relationship Between Equity-Based Compensation and Managerial Risk Taking: Evidence from China

The authors analyze the impact of equity-based compensation on managerial risk-taking behavior in Chinese listed firms from January 2006 to July 2011. They find that greater risk-taking incentives lead executives to invest more in research and development (R&D) projects and less in capital expenditures. Greater managerial risk-taking incentive increases firm focus. Managerial risk-taking incentives have positive effects on firms' leverage. Overall, increasing the sensitivity of chief executive officers' portfolio value to stock return volatility helps incentivize executives to work harder, as sharing gains and losses with shareholders aligns the interests of executives and shareholders. In addition, the results indicate that state control of firms has a negative effect on R&D investment, and this suggests that state-controlled firms should take more initiative to innovate.     

Takeover vulnerability and the credibility of signaling: The case of open-market share repurchases

There is debate in the literature focuses on whether open market repurchases can be taken as a signal of stock undervaluation. This research argues that takeover pressures before a repurchase announcement can be a credible signal of undervaluation. The empirical results indicate that repurchasing firms with a higher probability of takeover experience greater announcement effects, improvements in operating performance and long-run abnormal return, positive forecast revisions by financial analysts, and enhanced agreement between management and shareholders. These findings suggest that takeover probability and open-market share repurchases appear to constitute a double-signal for conveying stock undervaluation to the market.     

Insider trading and share repurchases: Do insiders and firms trade in the same direction?

Signaling undervaluation is often considered a primary motive for repurchasing stock, but insider trading activity by repurchasing firms is not always consistent with undervaluation. Net insider buying and selling are both more frequent in quarters when firms are repurchasing non-trivial amounts of stock, with the odds of observing a repurchase the highest in quarters with net insider selling. In multinomial logit models, share repurchases associated with net insider selling are positively related to illiquidity, option exercises by insiders, and pre-repurchase returns and negatively correlated with industry-adjusted book to market ratios when compared to other repurchases. Hence, repurchases when insiders are selling stock are more likely done to support share prices or avoid dilution and are less likely undervaluation signals. We find that insider trades either validate or mitigate the undervaluation signal of the repurchase. Abnormal returns of repurchasing firms with net insider buying versus net insider selling in a given quarter are significantly higher for the quarter immediately after the repurchase and the three subsequent years. For repurchases accompanied by net insider selling, abnormal returns are negligible after only one year.     

Share pledging,payout policy,and the value of cash holdings

Share pledging for insiders’ personal bank loans is associated with the agency problems of insider risk aversion and stock price crash risk. We examine the relation between insider share pledging and the value of cash holdings using the pledging data of listed firms in Taiwan. We find that the value of cash holdings is lower for pledging firms, especially for those that are relatively more risk averse. Pledging firms that repurchase shares have a higher marginal value of cash than those with other payout methods, likely due to the role of repurchases in reducing the stock price crash risk. Our results show how insiders’ personal financing incentives arising from share pledging would affect the value of cash holdings from the perspective of agency problems and payout policy.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

Why do stock repurchases change over time?

Recent studies have shown the time trends of firm stock repurchase behavior. We examine these time changes for stock repurchase through the lens of real activities earnings management. Managers appear more likely to manipulate earnings through stock repurchases since the passage of the Sarbanes–Oxley Act (SOX) in 2002. Furthermore, suspect firms that just missed analyst earnings per share forecasts have higher incentives to manipulate earnings through stock repurchases. The results are not driven by changes in corporate governance associated with the passage of SOX. Overall, our results suggest earnings management can be a significant determinant of the dynamics of stock repurchases.     

Cost Structure and Payout Policy

I investigate the effects of firms’ proportion of fixed and variable costs on their payout policy and find that firms with higher fixed costs have significantly higher volatility in their future cash flows and more variable future operating incomes. These firms pay a lower fraction of their operating income in dividends and share repurchases. Finally, these firms return higher fractions of their payouts via share repurchases because this method offers greater flexibility. The results are robust to several alternate specifications and firm‐level controls, and show that firms’ cost structures play a significant role in payout policy choices.     

Intraindustry Effects of Bank Stock Repurchases

Bank stock repurchases have become increasingly popular over time. Because of the unique capital requirements and regulatory constraints on the use of bank funds, the intraindustry effects of bank stock repurchases may differ from intraindustry effects of stock repurchases by other firms. We find that bank stock repurchases result in a positive and significant valuation effect for the repurchasing banks. Moreover, we find positive significant intraindustry effects of bank stock repurchases, unlike previous research by Hertzel on firms from numerous industries that found no evidence of intraindustry effects in response to stock repurchases. We attribute the difference in results to the unique characteristics of the banking industry, which results in a less ambiguous signal emitted from the stock repurchase announcement. In addition, we find that the intraindustry effects are more favorable when the valuation effect for the repurchasing bank is more favorable. This implies that the degree of signal to the industry is conditioned on the degree of signal about the bank that is repurchasing its shares. Furthermore, intraindustry effects are more favorable when the capital position of rival banks is high, when the proportion of residential loans of rival banks is low, and when the announcing bank is a money center bank.     

IPO anomalies and innovation capital

Innovation capital are typically expensed and/or unrecognized as assets under current generally accepted accounting principles. This results in accounting-related information asymmetry. This paper examines the association of innovation capital (as measured here by the proxies of R&D expenditures and granted patents) and initial public offerings (IPO) anomalies. These anomalies include initial IPO underpricing, duration of honeymoon (a distinct feature of the Taiwanese IPO environment), and long-term performance. The theoretical model underlying this research is a signaling model. The results indicate that more innovative firms are more likely to be underpriced, and have longer honeymoon periods than less innovative firms. Further, the more innovative firms have positive and growing long-term market-adjusted returns. This stands in contrast to the declining long-term stock performance of initial public offering firms that is evidenced in the literature. We conclude that pre-IPO research and development expenditures disclosed in the IPO prospectus, official monthly reports of newly developed patents released to the public, and the frequency of patent citations significantly signal both underpricing and future market performance of IPO firms in Taiwan.