Douglas J. Skinner and Venky Nagar
Executives Use Stock Buybacks to Manage Performance Results
Corporate executives' decisions to repurchase shares may have short-term benefits but costly long-term consequences.
ANN ARBOR, Mich. Corporate executives have incentives to use stock buybacks to manage the short-term performance results of their firms, according to a new study at the University of Michigan Business School.
Share repurchases can help companies increase earnings-per-share growth, mask earnings shortfalls and relieve selling pressure on stock prices when insiders are unloading large blocks of their own holdings. However, these short-term benefits may not always be in the best interests of a company and its shareholders in the long run.
Using cash to repurchase shares may force a firm to increase its borrowing or reduce its investment in good projects, both of which damp future earnings growth. Moreover, stock buybacks can obscure transfers of shareholder wealth to managers and enrich executives whose incentive pay is based on earnings-per-share growth.
In a study forthcoming in the Journal of Accounting and Economics, Douglas J. Skinner and Venky Nagar of the Michigan Business School and Daniel A. Bens and M.H. Franco Wong of the University of Chicago investigate whether corporate executives' stock-repurchase decisions are affected by their incentives to manage performance results, specifically, diluted earnings per share (EPS).
"Corporate executives manage diluted EPS for the same reasons they manage reported earnings more generally," says Skinner, professor of accounting at the Michigan Business School and also a Neubauer Faculty Fellow and visiting professor of accounting at the University of Chicago Graduate School of Business.
"Investors reward firms that report consistent earnings growth, consistently meet analysts' earnings forecasts and avoid earnings disappointments. Since earnings are usually reported on a per-share basis, and now most typically on a diluted per-share basis, these results are likely to apply to management of diluted EPS."
Relatively high stock prices and earnings not only increase the wealth of executives, whose compensation is often directly tied to these factors, but also improve company performance, reducing the risk that top management will be fired or censured by the board for poor results. In addition, a relatively high stock valuation and favorable comments from analysts can lower the shareholders' cost of raising more capital.
"These financial-reporting incentives play an important role in explaining share repurchases," says Nagar, an assistant professor of accounting at Michigan. "Executives have substantial discretion to time their firms' stock repurchases, which increase diluted EPS by reducing common shares outstanding."
To test their predictions, the researchers collected annual data on the total employee stock options outstanding and actual share repurchases made at 357 S&P 500 Industrial firms from 1996 to 1999. Stock repurchases during this period averaged $301 million.
They found that corporate executives raise the level of stock repurchases when there is an increase in the dilutive effect of employee stock option plans on diluted EPS. The share buyback offsets the unwanted effect of these securities, which otherwise would lower performance results. On average, firms repurchase 0.2 percent of beginning shares outstanding for every 1 percent increase in the number of dilutive potential common shares.
The researchers also report that corporate executives are more likely to undertake stock repurchases when earnings fall short of the levels needed to sustain prior growth rates in reported EPS. By increasing repurchases, and thereby reducing outstanding shares, they are able to counteract the negative effect of the earnings shortfall on performance results.
Generally, firms with high price/earnings ratios are less likely to do buybacks, they say. However, executives at these companies are relatively more responsive to potential ESO dilution when making repurchase decisions because they face severe economic consequences for missing earnings and EPS growth targets.
"Our results underscore the fact that executives' short-term financial-reporting objectives can affect their 'real' decisions, even when these decisions are costly in the long run," Skinner says.
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