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Feb. 18, 2004

Executives use stock buybacks to manage performance results

ANN ARBOR, Mich.—Corporate executives have incentives to use stock buybacks to manage the short-term performance results of their firms, according to researchers 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, they say. 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, the researchers say. 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 Skinner and Venky Nagar of the Michigan Business School, along with Daniel 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," said 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."

Skinner and colleagues collected annual data on the total employee stock options outstanding and actual share repurchases made at more than 350 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.

Contact: Bernie DeGroat
Phone: (734) 936-1015 or 647-1847
E-mail: bernied@umich.edu