Share Repurchases as a Tool to Mislead Investors:
Evidence from Earnings Quality and Stock Performance
2006 NTU Conference
Konan Chan, David Ikenberry, Inmoo Lee, and Yanzhi Wang
Presenter: Yanzhi Wang
Outline
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Background
Motivation
Data
Empirical results
– Summary statistics, quarterly earnings announcement
return, analysts forecasts revision, top-executive stock
option, long run buy-and-hold return, operating
performance, actual buyback status, factor model analysis,
etc. To save time, not all of them would be presented.
• Conclusion
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Background
• Why is repurchase important?
– Grullon and Michaely (2002) report that from 1983-2000,
spending by U.S. firms on share repurchases grew at a rate
of about 20% per year. This contrasts with the comparable
growth rate in dividends of only 6%.
– Compared to initial public offerings, aggregate repurchases
over this period were nearly three times greater than the
proceeds raised through IPOs. Stock repurchases have
gained increasing popularity since 1984. The aggregate
announced value amounts to $1,420 billion during 19802000, whereas 488 billion for IPOs.
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Background
• Why do firms announce repurchases?
– Signaling undervaluation
– Dividend substitute
– Free cash flow disgorgement
– Capital structure adjustment
– Prevention of dilution from employee stock option
– Defense against a hostile takeover
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Background
• How does the market react to repurchases?
– In the short run, repurchase announcement gains
significant AR of 1.79%
– 4 years post to repurchase announcement, long run
buy-and-hold return is 15.6%
– The positive AR provides the evidence that
repurchase is a good news to the market.
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Motivation
• Do we knowingly learn why firms announcement
repurchases?
– In 1998, Institutional Investor reported survey
results of CFOs as to why they repurchase stock.
Among the various choices was the category “to
support the stock.”
– Open-market buybacks given the structural
flexibility managers have to forego purchasing any
shares, thus announcements might be like the form
of “cheap-talk.”
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Motivation
• This inherent flexibility affords managers the chance to
initiate programs, even if their intention to acquire
stock is not based on a perception of misvaluation or
some other value-enhancing motive.
• However, such measures of managerial intent are
unobservable. Here, we consider earnings quality as a
proxy for the propensity of managers to potentially
mislead investors through a buyback program
announcement.
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Empirical Finding
• This paper considers whether manipulation of
investor expectations may be a primary factor in a
sub-set of repurchase announcements where
managers may be under pressure to otherwise support
stock prices.
• We do this by focusing on firms with low earnings
quality. Prior to the repurchase announcement, these
low earnings quality firms are desperate to take some
actions, and may serve open market share repurchase
announcement as an inexpensive means to send a
false signal to the market.
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Empirical Finding
• Initially, the market does not seem to pay attention to earnings
quality when buyback programs are first announced, which
suggests a pooling equilibrium. However, the stock returns of
firms with low earnings quality do not outperform in the longrun. The operating performance of these firms even shows
clear evidence of deterioration after the announcement. These
evidences are consistent with our manipulation story.
• We also check other possibilities in explanation of what low
earnings quality firm behaves; as a result, our hypothesis is the
most consistent explanation to the empirical results.
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Issue
• To investigate the misleading intend of buyback
programs, some key questions of interest are:
• Q1: Given that we cannot directly verify managerial
intent, is there any evidence which suggests that the
managers of buyback firms with low earnings quality
are under pressure to boost stock prices?
• Q2: Do we find any evidence that investors recognize
this pressure and react accordingly?
• Q3: Is the operating and long-run stock return
performance of suspect buyback firms worse
compared to the generally favorable case?
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Data
• We form a sample of open-market repurchase
announcements from two sources: Wall Street
Journal Index for the period 1980-1990, and
Securities Data Corporation (SDC) which begins
comprehensive coverage in 1985.
• To reduce time clustering, we eliminate
announcements that occurred in the fourth quarter of
1987. We exclude firms whose share price at the
time of repurchase announcement is below $3 to
avoid the skewness of the long term return. The final
sample includes 7,628 separate cases.
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How to Observe the “pressure”?
• Regarding the question why earnings quality could
proxy the managerial intent, we argue low earnings
quality firms suffer pressure and accordingly take
some actions (like buyback shares announcement).
• The pressures we observe include:
– Prior AR- low earnings quality and with poor prior
performance firms (High-L group)
– Quarterly announcement return
– Analysts forecasts revision
– Top-executive stock options holdings
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Operating performance
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Quarterly earnings ann. return
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Analysts forecasts revision
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Stock option of top-executives
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Answer to Q1
• Overall, the evidences here are consistent with the
idea that managers in high DA firms in our sample
may have been under pressure to reverse an otherwise
negative trend in market events, for example, the
quarterly announcement return and analysts’ forecast.
• From the view of stock options, top-executives of low
earnings quality firms both hold pessimistic prospect
and have greater incentives to lift the stock price up,
which is again consistent with the idea above.
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What’s the market reaction?
• In the short-run, we find that, consistent with the
evidence regarding earnings myopia, the market does
not sort out differences in earnings quality across
buyback programs as they are announced. In both
high and low earnings quality firms, the initial market
reaction is about the same, slightly higher than 2%
(shown in Table 1). This provides the answer to our
Q2.
• The result still holds even we control the other factors.
• This support a pooling equilibrium of open market
share repurchase announcement.
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Announcement Return Regressions
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Long run performance
• The low earnings quality firm who has the pressure
to lift its stock price intently announces share
buyback; since this repurchase announcement
doesn’t signal the good news, accordingly we argue
the performance of the low earnings quality firm
will not improve even deteriorate in the long run.
• Two measures of long run performance are
examined: the long run buy-and-hold return and
abnormal operating performance.
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Long run buy-and-hold return
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Abnormal operating performance
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Answer to Q3
• To the extent that a sub-set of buybacks is
manipulative in intent, we do not observe any
material long-term abnormal performance for low
earnings quality firms, either operationally or
measured by stock performance. This contradict to
the traditional signaling hypothesis suggesting
outperformance of repurchase announcement.
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