The Real Effects of Share Repurchases

Posted by Mathias Kronlund, University of Illinois at Urbana-Champaign, on Monday, February 8, 2016

Companies face intense pressure from activist shareholders, institutional investors, the government, and the media to put their cash to good use. Existing evidence suggests that share repurchases are a good way for companies to return cash to investors, since cash-rich companies tend to generate large abnormal returns when announcing new repurchase programs. However, some observers argue that the cash that is spent on repurchase programs should instead be used to increase research and employment, and that the recent increase in share repurchases is undermining the recovery from the recent recession and hurting the economy’s long-term prospects. Repurchases have also been cited as an explanation for why the increase in corporate profitability in the years after the recession has not resulted in higher growth in employment, and overall economic prosperity.

Is there any ground for these claims? Do share repurchases have real effects on other corporate policies such as employment and research and development (R&D)? Previous studies show a negative correlation between share repurchases and investment, but the standard interpretation for this correlation is that it is driven by variation in growth opportunities. That is, firms with poor growth opportunities reduce investment and direct resources towards share repurchases. If this standard interpretation is correct, then claims that repurchases reduce economic growth are incorrect: the reductions in investment would have occurred irrespective of the amount of repurchases. To test whether repurchases have causal effects on firm outcomes, we need to measure variation in repurchases that is not related to unobservable variation in growth opportunities.

In our paper, The Real Effects of Share Repurchases, recently featured in the Journal of Financial Economics, we propose such a test. The test exploits a discontinuity in the likelihood of share repurchases that is caused by earnings management considerations. There is a strong discontinuity in the probability of accretive share repurchases around the threshold at which the firm would narrowly miss the analyst earnings consensus, without conducting share repurchases. Thus, companies that would just miss their earnings per share (EPS) forecasts by a few cents absent executing a repurchase are significantly more likely to repurchase shares than companies that beat their EPS forecasts by a few cents.

We find that an increase in share repurchases made by firms that would have a small negative EPS surprise is associated with significant changes in other corporate policies. These companies tend to decrease employment, Capex, and R&D in the four quarters following increases in EPS-induced repurchases, relative to companies that just meet analyst EPS forecasts. The effects correspond to approximately 10% of the mean capital expenditures, 3% of the mean R&D expenses, and 5% of the average number of employees in our sample. The results support anecdotal and survey evidence that companies are willing to trade off employment and investment for stock repurchases.

We further exploit cross-sectional heterogeneity in the magnitude of the discontinuity in share repurchases around the zero surprise threshold. We show that the discontinuity in repurchases is much weaker or absent among firms that are financially constrained, and among firms that do not mention “EPS” or “Earnings Per Share” in their proxy statements. Financially constrained firms are less able to engage in large share repurchases to manage EPS, and firms that do not mention EPS in their proxy statement arguably care less about managing EPS. We find that among these firms that don’t respond as much by doing repurchases, there is little or no relationship between having a negative pre-repurchase EPS surprise and future employment/investment.

Finally, we study the consequences of EPS-induced repurchases for firm valuation and performance. We find that when firms change the sign of EPS surprise from negative to positive using repurchases, they experience a positive and significant cumulative abnormal return (CAR) around their earnings announcement. This abnormal return is virtually identical to that for firms that report positive EPS surprises without repurchasing shares. We find similar results for operating performance (measured by return on assets (ROA)). Further analysis uncovers interesting cross-sectional variation in stock price reactions and operating performance. Firms that cut some type of real investment (either Capex, employment, or R&D) in the same quarter as they achieve a repurchase-induced EPS surprise show a stock price reaction that is on average 0.23% lower than that of firms that change the sign of the EPS surprise without cutting any real investments (e.g., these firms could be using internal cash to finance the repurchase). Consistent with the valuation results, firms that cut investments in the same quarter as the earnings surprise have lower subsequent operating performance than firms that finance the repurchase with cash or internal cash flow.

These results suggest that EPS-induced repurchases are on average not detrimental to shareholder value or subsequent performance. The interpretation of the cross-sectional evidence is a bit trickier because the choice of how to finance a repurchase may be driven by factors that also influence performance. With this caveat in mind, the lower returns of firms that finance repurchases with real investments provide suggestive evidence that some firms are willing to sacrifice valuable investments to finance share repurchases.

The full paper is available for download here.