The Credibility of Stock Repurchase Signals

Chao Chen Min-Ming Wen

Information HypothesisAsymmetric information” or “signaling sto

ry”: A signal that the firm’s stock price is signi

ficantly undervalued Vermalen (1981, JFE) Dann and DeAngelo (1983, JFE) document tha

t stock Ikenberry, Lakonishok and Vermalen (1995, JF

E)

Alternative Observations

• Bartov (1991, JAE) Jagannathan and Stephenes (2003, FM)

• Grullon and Michaely (2003, JF)

• Huang, Liano, and Pan (2003) • Zhou and Lin (2004) • Kahle (2002, JFE)

Credibility of Repurchase Signals Stock repurchase signals are cheap to make,

because firms do not need to follow up on their announcements. (The Wall Street Journal and Fortune)

Billett and Xue (2003), false signal with the subsequent seasoned equity offerings

Kim, Schremper, and Varaiya (2004), the least stringent regulation on execution and disclosure of repurchase

Research Questions Do firms really do what they announced? Can it be a false repurchase signal sent by

managers who intend to benefit from it due to their employee stock options ready for exercise or other self motivated activities?

Is there any link between stock repurchase and earnings management?

Do firms with earnings management have a higher probability of leaving repurchase program incomplete?

Measures of Credibility and Earnings Management This study uses whether a firm

completed its repurchase program as a measure of the credibility of repurchase announcement.

Following Teoh, Welch and Wong (1998a, b), we use discretionary accruals as a measure of earnings management

Completed v.s Incompleted Completed repurchase program-- if the share

s that the board wants to repurchase under the authorization have been repurchased.

Incompleted repurchase: (i) Temporarily suspended by the board(ii) the repurchase authorization is withdrawn by the board

Incomplete Repurchase A typical repurchase program lasts for three

years (Stephens and Weisbach 1998) Incompleted status means that up to Jan

uary 2003, firms that had announced repurchase programs between 1995 and 2000 did not complete the repurchase.

Hypothesis 1: Earnings management neutral hypothesis Based on the information hypothesis, if a

firm announces its intention to repurchase stock, the firm should be neutral on earnings management.

Thus, the discretionary current accruals before and after the announcement of stock repurchase will be indifferent.

Implications A rejection of the null hypothesis: (i) is in favor of the existence of earnings

management prior to the announcement of stock repurchases(ii) indicates that stock repurchase firms shift future earnings prior to the announcement.(iii) ROA will be negatively correlated with pre-stock repurchase discretionary current accruals

Hypothesis 2: Managerial entrenchment hypothesis If top managers decide to leave the stock

repurchase program incomplete, the negative effect of earnings management prior to repurchase announcements on future earnings changes will be more severe.

Implication Following hypothesis 2 and the rejection

of hypothesis 1 => if a firm has a greater incentive of mani

pulating earnings, the credibility of stock repurchase can be lower so that the probability of leaving the repurchase program incomplete is higher.

Data and Sample The Securities Data Corporation’s (SDC)

Worldwide Merge and Acquisition database Firms made the repurchase initial

authorization between 1995 and 2000. COMPUSTAT data up to 2002 Non-financial firms

Data and Sample Panel A of Table 1 presents the number of fir

ms initialized repurchase programs in each sample year and the frequency and percentage of completed v.s. incompleted repurchase.

Table 1 Completed(i) Incomplete(ii) Total

Frequency Percent Frequency Percent 1995 75 44.4% 94 55.6% 169

1996 128 53.8% 110 46.2% 238

1997 124 46.4% 143 53.6% 267

1998 136 31.0% 303 69.0% 439

1999 83 29.1% 202 70.9% 285

2000 53 21.4% 195 78.6% 248

Methodology (1) Earnings management model Following Teoh, Welch, and Wong (1998a, J

F, 1998b, JFE) methodologies.(2) Logistic Model

Methodology Cross-sectional regression of the change in return on

asset (∆ROA) in year 1 and year 2 on variables in year –1:

∆ROAi, t+j=α1+δ1 DCAi, t-1 +δ2 NDCA i, t-1 +δ3 (OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j

∆ROAi, t+j (j=1 or 2) = α1+ δ1TotalCAi, t-1 + δ3

(OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j

Empirical resultsI. Testing earnings management hypothesisTable 2

Table 2 Year -2 -1 0 1 2 Observation NI 1521 1625 1646 1540 1213 DCA 1454 1574 1599 1500 1177 NDCA 1493 1609 1486 1534 1208 OCF 1519 1625 1635 1540 1213 Mean NI 6.562a 6.716 a 5.479 a 3.712 a 3.754 a DCA 0.581 0.946b 1.101a -0.207 -0.528b NDCA 3.267a 2.796a 0.839a 0.899a 1.040a

OCF 11.198 a 10.458 a 10.108 a 10.155 a 9.923 a Median NI 6.980a 7.192 a 6.409 a 5.166 a 4.825 a DCA 0.199 0.355a 0.353a -0.101 -0.498a

NDCA 0.950a 1.059a 0.660a 0.511a 0.509a

OCF 10.543 a 11.254 a 10.676 a 10.419 a 10.337 a

Implications of Table 2 DCA > 0 if t =-1, 0; DCA < 0 if t =1,2 Consistent with Bartov (1991), Jagannathan

and Stephenes (2003), and Grullon and Michaely (2004)

Results of Table 2 suggest the possibility that earnings management exists among the firms intended to buyback their shares.

Regression results: Table 3 Panel A:

Intercept DCA NDCA OCF MV R2 ADJ-

R2 N F

∆ROAi,t+1

-0.01

(-1.35) -0.04

(-1.21) -0.11a

(-3.09) -0.07a

(-3.40) -0.04a

(-6.14) 0.036 0.033 1301 12.05 a

∆ROAi,t+2

0.01 (0.41)

-0.16a

(-2.92) -0.23a

(-3.93) -0.15a

(-5.43) -0.03

(-1.43) 0.040 0.036 1018 10.48 a

Results Table 3 Non-discretionary current accruals, operating

cash flows, and size have a significantly negative effect on the changes of returns on asset one year after repurchase.

Discretionary current accruals inversely and significantly affects the post-repurchase performance of firms.

Results: Complete v.s. Incomplete Results of imposing equation (5) on the

completed and incompleted groups

Empirical Results Comparisons of post-stock repurchase an

nouncement ROA of completed and incompleted groups

Table 4A: the descriptive statistics of firm size and repurchase contents (number of shares and the percentage of targeted shares) of completed and incompleted firms

Table 4 Panel A Descriptive Statistics of Repurchase Shares and Percentage of

Targeted Repurchase Shares

Group Shares(i) Percent(ii)

Total assets (iii)

Mean Completed 3400386 6.37 2694.86 Incomplete 3584094 7.86 2222.50

Standard Deviation Shares Percent Total assets Completed 6854995 5.32 10973.93

Incomplete 8093569 6.52 11093.14

Table 4 Pane B Regression Results Intercept DCA NDCA OCF MV ADJ-

R2 N F

Completed ∆ROAi,t+1

0.03a -0.04 -0.35a -0.18a -0.03 0.07 492 10.78 a (3.08) (-0.84) (-4.45) (-4.16) (-1.29)

∆ROAi,t+2 0.03b -0.11 -0.25a -0.27a -0.08a 0.08 428 10.37 a (2.37) (-1.36) (-2.65) (-4.79) (-2.75)

Incomplete

∆ROAi,t+1 -0.02a -0.08c -0.04 -0.05b -0.03a 0.03 809 7.35 a

(-3.13) (-1.75) (-1.10) (-1.99) (-5.13) ∆ROAi,t+2

-0.01 -0.20a -0.19b -0.16a -0.01 0.02 590 4.35 a (-0.90) (-2.82) (-2.32) (-3.05) (-0.38)

Results: Table 4B(1) Incomplete firms: significant negative effects of earnings management prior to repurchase announcements on both ∆ROAi,t+1 and ∆ROAi,t+2

(2) Completed firms: discretionary current accruals prior to repurchase announcements have insignificant negative effects on both ∆ROAi,t+1 and ∆ROAi,t+2.

Table 5

Comparison of ROA of the complete and incomplete repurchase groups

(i) ∆ ROA Group = ROA (Complete) – ROA (Incomplete) (ii) % ∆ in ROA = [ROA(t+i) – ROA(t+i-1)]/ROA(t+i-1), i = -1, 0, 1, 2.

Median Mean (t-2) (t-1) t0 t+1 t+2 (t-2) (t-1) t0 t+1 t+2 ROA (Complete)

0.0871 0.0949 0.0880 0.0727 0.0660 0.1025 0.1130 0.0923 0.0826 0.0694

% ∆ in ROA(ii)

8.96% -7.27% -17.39% -9.22%

10.24% -18.32% -10.51% -15.98%

ROA (Incomplete)

0.0806 0.0827 0.0680 0.0501 0.0396 0.0968 0.0606 0.0664 0.0416 0.0351

%∆ in ROA 2.61% -17.78% -26.32% -20.96% -37.40% 9.57% -37.35% -15.63% ROAGroup

(i) 0.65%a 1.22%a 2.00%a 2.26%a 2.64%a

0.57% (0.13)

5.24%a

(2.77) 2.59%a

(2.88) 4.10%a

(4.75) 3.43%a

(3.18)

Methodology-- Logistic model To link the probability of leaving a

repurchase program incomplete and the incentives of earnings management

Logit Model Logit (p) = log (p/1+p) = α + ß’ x p -- the probability of leaving a repurchase progra

m incomplete and defined as Pr (Y = 1 | x ), Y =1 if the repurchase program is incompleted, Y = 0, otherwise

x is a vector of explanatory variables(i) pre-stock repurchase discretionary current accruals, (ii) the number of shares firms intended to buyback, (iii) firm size, (iv) debt ratio, (v) whether the firm disclose the funding source of repurchase.

p = e ßX/(1+eßx).

Table 6 Logistic Regression Model

Variables Parameters Estimate

Chi-Square

Intercept 0.020 0.006 DCA(t-2) -0.176 0.451 DCA(t-1) 19.381c 2.993 DCAt -1.881 1.087 DCA(t+1) 16.134 0.611 NDCA(t-1) 2.152 0.035 OCF(t-1) 0.215 0.271 PercentShare 0.052a 17.774 DE(t-1) 0.014 0.113 lnTA(t-1) -0.041 1.375 Dummy 0.470a 14.456

Empirical Results: Logistic regression model

(1) firms with higher pre-stock repurchase discretionary accruals tends to have significantly higher probability leaving the repurchase program incomplete.

(2) Higher discretionary accruals prior to the stock repurchase suggest a greater incentive of managing earnings.

(3) A linkage between the probability of conducting earnings management and the probability of leaving repurchase program incomplete.

ConclusionsThe earnings management

inversely and significantly affects the post-repurchase performance of firms with incomplete repurchase programs.

Stock repurchase may be a false signal and the firm’s value may actually be overvalued

Conclusions firms with higher pre-stock repurchase

discretionary accruals tend to have significantly higher probability leaving the repurchase program incomplete.

Methodology Current accrual (CA) model :

CAi,t = [ARi,t + INVi,t + OCAi,t ] - [APi,t + TPi,t + OCLi,t ] (1)

Discretionary and nondiscretionary accruals for a given year,

= a0 ∙ + a1∙ + εi,t (2)

1,

,

ti

ti

TACA

1,

1

tiTA1,

,

ti

ti

TASales

Methodology CAi,t = the current accruals of firm i at year t, ARi,t = accounts receivables, INVi,t = inventory, OCAi,t = other current assets, APi,t = account payable, TPi,t = tax payable, and OCLi,t = other current liabilities. Salesi,t = the change in sales from the previous y

ear (t-1) for firm i. TA = Total Assets

Methodology Nondiscretionary current accruals (NDCA) :NDCAi,t = ∙ + ∙ (3)

ARi,t = the change in account receivable in year t for firm i.

and are the coefficients estimates from equation (2)

^

0a1,

1

tiTA

^

1a1,

,,

ti

titi

TAARSales

^

0a^

1a

Methodology The scaled discretionary current accruals (DCA) :DCAi,t = - NDCAi,t (4)

DCAi,t is used for the proxy of earning management

1,

,

ti

ti

TACA

Equations for Accruals

Total Accruals = Changes in Net Operating Assets (NOA) =(NOAt – NOAt-1)/NOAt-1

NOA = Operating Assets (OA) – Operating Liabilities (OL) OA = Current Operating Assets + Non-current OA (NCO

A) OL = Current Operating Liabilities (COL) + Non-COL (NC

OL) COA = Current Assets (CA) – Cash and Short Term Inves

tments (STI) NCOA = Total Assets (TA) – CA – Investments and Adva

nces COL = CL – Debt in Current Liabilities NCOL = TL – Current Liabilities – Long-term debt SG = sales growth = (Salest – Salest-1) - 1