Share repurchases of initial public offerings: motives,valuation effects,and the impact of market regulation

This study investigates the motives and valuation effects of share repurchase announcements of German firms during the 1998–2008 period, addressing the question why initial public offering (IPO) firms repurchase shares soon after going public. While our focus is on IPO firms, we also examine the impact of firm size by differentiating between IPO and established DAX/MDAX firms and by analyzing the source of surplus cash holdings, that is, either from equity issuances or from operating cash flows. We further explore the impact of the regulatory environment. Our empirical analysis reveals significant differences between the IPO and DAX/MDAX subsamples regarding their repurchase motives, stock price performance, and explanatory factors. Standard corporate payout theories are essential in explaining the different valuation effects. Our empirical analysis suggests agency costs of free cash flow as the main reason for the observed valuation effects of both IPO and DAX/MDAX firms, yet for different reasons. While DAX/MDAX firms continuously generate high operating cash flows before and after repurchasing shares, IPO firms exhibit low operating cash flows during the entire period but large surplus cash holdings due to the mandatory equity issuance at their public offering. Overall, the repurchase decisions of IPO firms are best explained by the agency costs of cash holdings and the unique rules and regulations of the German stock exchange.     

STOCK BUYBACKS, CORPORATE PERFORMANCE, AND EVA

Most studies of corporate stock repurchase focus on the effect of stock buyback announcements on the stock price performance of companies announcing the programs, and on the corporate motives for undertaking stock buyback programs. The study described in this article examines the effects of actual stock buyback activities on corporate performance, addressing the question whether buybacks are associated with increases in economic value or EVA. In general, the study reports that the operating performance of buyback companies is better than that of non-buyback companies, and that performance improves in the year following the initiation of repurchasing activities. Although it is not the central focus of this study, the findings are consistent with both the free cash flow and the information signaling hypotheses as motives for engaging in stock buybacks.     

If It's Good for the Firm,It's Good for Me: Insider Trading and Repurchases Motivated by Undervaluation

My findings suggest that information inherent in insider trading can be used to identify undervalued repurchasing firms. I examine the relation between insider trading and the performance of open market repurchase (OMR) firms. I show that firms with high net insider buying prior to OMR announcements not only earn abnormal stock returns in both the short‐ and long‐run, but also exhibit better operating performance. Overall, the evidence is consistent with insiders timing their trades prior to OMR announcements.     

Do Corporate Managers Know When Their Shares Are Undervalued? New Evidence Based on Actual (and Not Just Announced) Stock Buybacks

This article summarizes the findings of the authors' recent study, published in the Journal of Financial Economics, of whether public companies are able to repurchase their own shares at a discount to the market, thereby earning more than a market return on such “investments.” To the extent the answer is yes, it would suggest that management has an advantage in assessing the intrinsic value of the companies they manage. Using as their sample all 2,237 publicly traded U.S. companies that repurchased their own stock between 2004 and 2011, the authors compared the average price paid during the month to the average price at which the firm's shares traded during that month as well as three and six months after the repurchase. (All earlier studies had measured stock performance from the date of the repurchase announcements rather than from the date of the actual repurchases.) The authors' conclusion, which may come as more of a surprise to financial economists than practicing corporate executives, was that the majority of companies repurchasing their shares have in fact earned a positive return on their investment in their own stock. Perhaps the most important finding of the study, however, was that infrequent repurchasers—defined as companies that bought back their own stock four or fewer times a year—have been much more successful in buying undervalued shares than regular repurchasers. For example, when evaluated over a six‐month holding period, the annual “alpha” of infrequent repurchasers was 2.4% greater than that of frequent repurchasers—those that bought back their shares at least nine times a year. And this advantage was even more significant for companies that repurchased just once during the year—a group that recorded an alpha of 5.9%, as compared to 1.5% for monthly repurchasers. Moreover, the results were essentially the same when extended over considerably longer holding periods. For the entire sample of companies that repurchased their shares, the authors reported finding positive and significant alphas of 0.3% per month over windows ranging from three months to three years after the repurchase. But, as reported above, the infrequent repurchasers significantly outperformed frequent repurchasers over all time horizons, with differences in alpha that ranged from a low of 0.3% and to as high as 0.6% per month.     

Stock repurchases: A further test of the free cash flow hypothesis

This study explores the empirical puzzle currently existing regarding the observed positive stock price reaction associated with self-tender offer announcements. The puzzle stems from Lang and Litzenberger's (1989) findings that Jensen's (1986, 1989) free cash flow (overinvestment) hypothesis is consistent with changes in cash dividends, whereas Howe, He and Kao's (1992) study of analogous cash events (i.e., self-tender offers and specially designated dividends) finds no support for the free cash flow hypothesis. By stratifying our sample of firms repurchasing their stock by the source of the firm's free cash flow (overinvestment) problem, additional light is shed on the interaction between the signalling and free cash flow theories.     

The Wealth Effects of Repurchases on Bondholders

Prior research has documented positive abnormal stock returns around the announcements of repurchase programs; several explanations of these returns have been suggested, including signaling, free cash flow, and wealth redistributions. This study analyzes abnormal stock, bond, and firm returns around repurchase announcements to examine these hypotheses. We find evidence consistent with both signaling and wealth redistribution. The loss to bondholders is a function of the size of the repurchase, and the risk of the firm's debt. We also find that bond ratings are twice as likely to be downgraded as upgraded after the announcement of the repurchase program.     

AN EMPIRICAL INVESTIGATION OF STOCK DIVIDENDS-IN-KIND

We investigate share price reactions to announcements of dividends payable in the common stock of corporations different from the issuing firm. We find that firms that declare these dividends (typically investment companies) experience positive abnormal returns upon announcement. We also find that such dividends are more likely to be declared when the shares to be distributed have peaked in value. Consistent with this finding, we document negative announcement-period abnormal returns for firms having their shares distributed. Additional tests reveal that prices respond more negatively when the information signal is strongest, when outside ownership is more dispersed, and when management is more entrenched.     

Price Performance Following Share‐Repurchase Announcements by Closed‐End Funds

We investigate the price performance of closed‐end funds that announce share‐repurchase programs. Closed‐end funds experience positive average stock‐price reactions to the announcements. The long‐run buy‐and‐hold abnormal returns of repurchasing funds over the subsequent three years are significantly higher than a nonrepurchasing control sample matched by size, type, investment style and geographic diversification. Funds with larger discounts, international funds, equity funds, and funds that announce larger repurchases or frequently announce repurchases, experience more positive stock‐price reactions. Except for larger repurchases, the same characteristics are associated with more positive long‐run buy‐and‐hold returns.     

The Information Content of Share Repurchase Programs

Contrary to the implications of many payout theories, we find that announcements of open‐market share repurchase programs are not followed by an increase in operating performance. However, we find that repurchasing firms experience a significant reduction in systematic risk and cost of capital relative to non‐repurchasing firms. Further, consistent with the free cash‐flow hypothesis, we find that the market reaction to share repurchase announcements is more positive among those firms that are more likely to overinvest. Finally, we find evidence to indicate that investors underreact to repurchase announcements because they initially underestimate the decline in cost of capital.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerged was that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial fl exibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

Mimicking repurchases

We study the tendency of firms to mimic the repurchase announcements of their industry counterparts. We argue that a firm, by repurchasing its shares, sends a positive signal about itself and a negative one about its competitors. This induces the competing firms to mimic the behavior of the repurchasing firm by repurchasing themselves. Using a broad sample of US firms from the period 1984–2002, we show that, in concentrated industries, a repurchase announcement lowers the stock price of the other firms in the same industry. The other firms react by repurchasing themselves to undo these negative effects. Repurchases are chosen as a strategic reaction to other firms’ repurchase decisions and are not motivated by the desire to time the market, i.e., to take advantage of a significantly undervalued stock price. Therefore, repurchasing firms in more concentrated industries experience a lower increase in value in comparison with their counterparts in less concentrated industries in the post-announcement era. Alternative methodologies used to estimate long-term performance confirm that it is only the repurchasing firms in low concentration industries that outperform the market, their non-repurchasing peers, and their counterparts in more concentrated industries by amounts that are economically and statistically significant.     

A comprehensive examination of the wealth effects of recent stock repurchase announcements

The main purpose of this paper is to examine the wealth effect of stock repurchase announcements using a sample of 11,862 repurchase programs announced during 1994–2007. The results of several recent industry surveys indicate that managerial motivations for repurchasing shares may have changed in recent years. To better understand the reasons for repurchasing shares we classify our sample in various ways—by year, by the method used for repurchasing shares, and by the stated purpose of the program. We find that the median size of firms repurchasing shares has increased dramatically recently, and concomitantly, the announcement returns have declined. Signaling undervaluation of share prices appears to become less important than previously assumed. While smaller firms signal undervaluation using open market repurchases, tender offers are chosen to enhance shareholder values by other means.     

Payout policy,financial flexibility,and agency costs of free cash flow

This paper explains how firms choose between dividends and open-market repurchase programs, the prevailing method that firms use to disburse cash today. While earlier theories about payout policy are motivated by signaling, the motivation for payout in this paper is to prevent the waste of free cash by self-interested insiders. In the model, dividends prevent free cash waste by forcing cash out, but result in underinvestment if the cash paid out is later needed for operations. Open-market programs stimulate payout by providing personal gains to informed insiders that are associated with the firm's repurchase trade. Yet, they also avoid the underinvestment problem by leaving insiders the option to cancel the payout. Because their execution is optional, however, open-market programs only partially prevent the waste of free cash. The model provides testable predictions that are generally consistent with the empirical evidence.     

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.     

Short‐selling constraints and corporate payout policy

This study shows that managers adjust corporate payout policies to counteract intensified short‐selling pressures following the removal of a short‐selling constraint. We use a controlled experiment, the Regulation SHO pilot program, to find that changing the short‐selling rule brings small companies to increase cash dividends, but not to repurchase more shares. Because paying dividends is costly, it is acknowledged as a more reliable signal of stock undervaluation than share repurchase. While our evidence suggests that companies select this payout strategy to deter predatory short sellers, it also shows that a short‐selling activity has a causal effect on corporate payout decisions.     

MORGAN STANLEY ROUNDTABLE ON Capital Structure and Payout Policy

A group of distinguished finance academics and practitioners discuss a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerges is that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial flexibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value both by reducing taxes and controlling the corporate free cash flow problem. In such cases, both leveraged financing and cash distributions through dividends and stock buybacks signal management's commitment to its shareholders that the firm's excess cash will not be wasted on projects that produce low‐return growth that comes at the expense of profitability. As for the choice between dividends and stock repurchases, dividends provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve more flexibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial flexibility: too little can mean lost investment opportunities, but too much can lead to overinvestment.     

Accelerated share repurchases

Accelerated share repurchases (ASRs) are credible commitments by firms to repurchase shares immediately. Including an ASR in a repurchase program reduces the flexibility that firms have to alter an announced program in response to subsequent changes in the price and liquidity of its shares, unexpected shocks to cash flow and/or investment, etc. Thus, we investigate whether firms' decisions to include ASRs in their repurchase programs are associated with factors expected to influence the costs of lost flexibility and the benefits of enhanced credibility and immediacy. We find robust evidence consistent with the costs of lost flexibility and the benefits of credibility and immediacy being important determinants of ASR adoption. Additionally, we find that ASR announcements are associated with positive average abnormal stock returns.     

Anomalous Price Behavior Around Repurchase Tender Offers

This paper reports anomalous price behavior around repurchase tender offers. Buying shares before the expiration date of a repurchase tender offer and tendering to the firm produces, on average, abnormal returns of more than 9 percent over a period shorter than one week. In addition, we find that repurchasing companies experience economically and statistically significant abnormal returns in the two years after the repurchase. The upward price drift is mainly caused by the behavior of the small firms in the sample.     

Payout Policy with Legal Restrictions

We hypothesize that firms that face limitations on debt may use increased dividend payments to mitigate the free cash flow problem. Limitations on debt are implicit in state laws that restrict the firm from making payouts when the asset‐to‐liability ratio is low. We find that: 1) firms incorporated in states with stricter payout restrictions pay more dividends, 2) the probability of paying dividends or repurchasing shares decreases as firms approach a binding payout constraint, and 3) bonding with dividends is less prevalent with increased managerial equity holdings. In addition, antitakeover and director liability laws have a less consistent effect on payout policy.     

THE INTRA-INDUSTRY EFFECTS OF OPEN MARKET SHARE REPURCHASES: CONTAGION OR COMPETITIVE?

We examine the extent to which announcements of open market share repurchase programs affect the valuation of competing firms in the same industry. On average, although firms announcing open market share repurchase programs experience a significantly positive stock price reaction at announcement, portfolios of rival firms in the same industry experience a significant and contemporaneous negative stock price reaction. This suggests that perceived changes in the competitive positions of the repurchasing firms occur at the expense of rival firms and dominate any signals of favorable industry conditions. Thus, the competitive intra-industry effects of open market repurchases outweigh any contagion effects. In addition, cross-sectional tests indicate that these competitive effects are more pronounced in industries characterized by a lower degree of competition and less correlation between the stock returns of the repurchasing firm and its rivals.