Even though the stock market is relatively flat, many companies are showing signs of life. We see this in rising share prices and dividend payoff. Still, there have been a flurry of comapnies, including Mircosoft, Monsanto and Intel, that have increased their plans to increase stock. Companies opt to repurchase their own stock for a variety of reasons: to signal that their stock is undervalued; to fulfill the exercise of options; to return excess cash to shareholders or to inflate their earnings-per-share (EPS). According to new research from a business school professor at Washington University in St. Louis, repurchasing stock enables firms to manage their EPS, the most salient financial indicator in the capital markets.
When managers realize that their corporate earnings per share are in jeopardy of falling short of analysts’ quarterly forecasts, they usually look for a way to avoid that fate. While there has been plenty of research that looks at how companies beat analysts forecast by manipulating their earnings, the effects of stock repurchases has remained unexamined. A new study co-written by assistant professor of accounting Nicole Thorne Jenkins in the Olin School of Business at Washington University in St. Louis, finds that under the right circumstances, repurchasing stock in an attempt to increase earnings per share does not completely fool the market, although it is an effective way to avoid being throttled when earnings per share fall short of market expectations.
Jenkins and her co-authors, Paul Hribar at Cornell University and Bruce Johnson at the University of Iowa, examined more than 133,000 firm quarters from 1988 through 2001. Of those firms 19 percent repurchased some of their outstanding shares.
“Of that 19 percent we found a significant number of firms that would have failed to meet analysts’ forecasts had they not engaged in a stock repurchase,” Jenkins says. “By engaging in the buyback, these firms were able to beat market expectations by one or two pennies. That may not seem like a lot, but research shows that if you fail to meet analysts’ forecasts by even a penny, the stock market will severely hammer your stock price.”
“Ultimately, these repurchases do not completely fool the market,” Jenkins says. “We looked at three-day returns around the earnings announcement date and it’s clear that investors recognize and discount the portion of earnings per share surprise that is due to stock repurchases relative to operating earnings. However, the discounting of stock repurchases is not as severe as what would have occurred had the stock buyback not occurred and the firm had missed their analyst forecast.”
According to Jenkins, 11 percent of firms that engaged in stock buybacks beat analysts’ forecasts by just a penny or two. The stock price of those companies may not have received the premium associated with beating market expectations through operating earnings, but they were successful in avoiding the torpedo effect to their stock price that is assessed when firms fail to meet market expectations. Firms that were well above analysts’ forecasts repurchase to signal to the market place that their stock is undervalued. Ordinarily the market positively prices this, Jenkins says, but her report demonstrates that the market can distinguish between the two reasons for repurchasing.
Repurchasing ones own stock can lead to a mechanical increase in a firm’s EPS that may not represent an increase in a firm’s real value. As firms repurchase their own stock, both the numerator and denominator of their EPS decline at differential rates. The decline in the denominator is a function of the number of shares repurchased as well as the timing of the repurchase. The decline in earnings is a function of the cost of acquiring cash for the repurchase as well as the return that the company forfeits by not investing that cash in positive net present value (NPV) projects within the firm. If a firm is unable to earn a return on excess cash that is greater than the inverse of their price-to-earnings (PE) ratio, then the execution of a stock repurchase plan will lead to an increase in EPS. For example if a firm earned 5% in after tax profits, a stock repurchase would lead to an increase in their EPS only if their price-to-earnings (PE) ratio was less then 20 (i.e. their earnings-to-price ratio was above 5%).
On October 26, 2005, Monsanto announced its plans to repurchase $800 million of their company stock over the next four years. Monsanto’s PE ratio is approximately 62, indicating their inverse PE ratio is 1.6%. It is likely that Monsanto can earn more then 1.6% after taxes on their internal investments. If over the next four years, Monsanto’s PE ratio does not substantially decline, investors can rest assured that the increases in the company’s reported EPS are being driven by changes in operating earnings rather than a mechanical increase powered by the repurchase of company stock.
The issue of the effect of stock repurchases on EPS and how the market prices stock repurchases is further discussed in her forthcoming article “Stock repurchases as an earnings management device.” The article will be published in the “Journal of Accounting and Economics.”