WHY DO FIRMS BUYBACK THEIR SHARES? AN ANALYSIS OF
OPEN MARKET SHARE REACQUISITIONS BY U.K. FIRMS
Dennis Oswald† and Steven Young‡
First version: August 2002
This version: November 2002
†London Business School, Regent’s Park, London, NW1 4SA, UK. Tel. ++44 (0) 207 262 5050. Email [email protected]. ‡Department of Accounting & Finance, Lancaster University, Lancaster, LA1 4YX, UK. Tel. ++ 44 (0) 1524 594242. Email [email protected]. We are grateful to John O’Hanlon, Ken Peasnell and seminar participants at Cardiff, Lancaster, London Business School, Swansea, the 2002 Annual Meeting of the British Accounting Association and the 2002 European Financial Management Association Annual Meeting for helpful comments and suggestions. We also acknowledge excellent research assistance provided by Anuradha Jayaraman and Jennifer Johnson. Financial support was provided by the Economic and Social Research Council (contract #R000223516) and London Business School.
ABSTRACT
WHY DO FIRMS BUYBACK THEIR SHARES? AN ANALYSIS OF OPEN
MARKET SHARE REACQUISITIONS BY U.K. FIRMS
This paper explores the determinants of share reacquisitions by U.K. firms over the
period January 1995 to December 2000. We find that the repurchases appear to be
used to distribute surplus cash and exploit perceived underpricing. Further analysis
reveals that the surplus cash effect is more pronounced for firms characterised by low
leverage and a limited investment opportunity set. Limited evidence also indicates
that the association between share reacquisitions and surplus cash is stronger in the
presence of poor contemporaneous share returns, consistent with the view that
distributions of excess cash are timed to create further value for shareholders.
Contrary to predictions, however, the probability that a firm distributes surplus cash
via a share repurchase is lower when the underpricing occurs in the year prior to the
repurchase.
Keywords: Share repurchases, surplus cash, underpricing
Running title: Share Repurchases in the U.K.
WHY DO FIRMS BUYBACK THEIR SHARES? AN ANALYSIS OF OPEN
MARKET SHARE REACQUISITIONS BY U.K. FIRMS
1. INTRODUCTION
Despite extensive research in the U.S., the reason why firms buy back their
shares remains the subject of considerable debate. Among the list of suggested
explanations are buying ‘cheap’ stock when managers perceive the firm is
undervalued (Ikenberry et al., 2000 and 1995; Vermaelen, 1981), distributing excess
cash (Fenn and Liang, 2001; Dittmar, 2000), adjusting capital structure (Dittmar,
2000) and funding employee share option exercises (Kahle, 2002; Dittmar, 2000).
Further, with share buybacks now becoming increasingly popular in non-U.S.
jurisdictions (Ikenberry et al., 2000: 2373), the generalisability of prior U.S. findings
to different institutional environments is also unclear (Rau and Vermaelen, 2002:
245). Accordingly, this paper examines the determinants of open market share
repurchases in the U.K. with the objective of developing a more complete
understanding of their incidence, rationale and potential shareholder wealth effects.
Share repurchase activity is currently growing at a dramatic rate in the U.K.
According to evidence presented by Rau and Vermaelen (2002) and Lasfer (2001), the
U.K. accounts for between 60% and 70% of total European repurchase announcement
activity. In one of the few studies to examine share buybacks in the U.K., Rees (1996)
reports evidence of a positive price reaction to announcements that open market
repurchases have taken place. More recently, Rau and Vermaelen (2002) examine
U.K. share repurchase activity and conclude that the form and intensity of buybacks is
primarily influenced by their tax consequences for pension funds. Oswald and Young
(2002a) re-examine Rau and Vermaelen’s (2002) findings and arrive at different
1
conclusions. Using a more comprehensive dataset, they conclude that Rau and
Vermaelen’s (2002) tax results are driven by sample selection bias. Instead, Oswald
and Young (2002a) find that repurchasing firms are characterised by poor stock
market performance in the period leading up to the buyback announcement, consistent
with the view that buybacks are driven by a perception that the firm is undervalued.
However, Oswald and Young (2002a) do not consider alternative explanations for
buybacks such as distributing excess cash or adjusting capital structure. As such, the
reasons why U.K. firms repurchase their shares remain unclear.
In this paper, we test a range of theories why firms repurchase their shares. We
focus on actual share reacquisitions (as opposed to announcements of repurchase
intentions or executions) because prior research suggests that repurchase
announcements provide a potentially poor proxy for the actual volume of shares
bought back (Ikenberry et al., 2000; Stephens and Weisbach, 1998). We restrict our
analysis to open market buybacks because self-tender offers and other off-market
repurchase methods are used only rarely in the U.K. We begin by analysing the
reasons disclosed by management for the buyback. Consistent with extant theory,
firms cite undervaluation and the desire to distribute excess cash amongst their list of
repurchase reasons. Other frequently cited reasons such as ‘improving earnings per
share’ and ‘increasing balance sheet efficiency’ are more difficult to interpret. Further,
almost one third of our sample fail to disclose any reason for the repurchase. We
conclude that management disclosures are capable of providing only limited insights
into the drivers of share repurchases.
In an attempt to shed further light on the determinants of open market share
reacquisitions, we undertake two complementary empirical analyses. First, we
compare the characteristics of repurchasers with a matched sample of
2
nonrepurchasing firms. Secondly, we model the value of shares repurchased using
only those firms that report at least one open market share reacquisition during our
sample period. Our results suggest that both the probability and value of shares
repurchased are associated with high cash holdings and a poor returns history. These
results are consistent with the view that share buybacks are used to distribute surplus
cash and exploit perceived underpricing, respectively. Further analysis reveals that the
positive link between cash holdings and repurchase probability is more pronounced
for firms with low gearing. To the extent that buybacks increase the gearing ratio, our
results suggest that concerns over the increased risk of financial distress may act as a
brake on the use of repurchases as a cash distribution mechanism. We also find that
the positive association between cash holdings and the value of shares reacquired is
stronger when investment opportunities are more limited. These results support the
view that repurchases are a response to the agency problems of surplus cash.
Besides boasting one of the highest levels of share repurchase activity of any
country outside the U.S., several additional factors make the U.K. a potentially
interesting setting in which to explore share buybacks. First, the tax and regulatory
environment in the U.K. differs in a number of important ways from that faced by
U.S. firms. This makes the U.K. an attractive setting in which to assess the
generalisability of extant U.S. findings. Secondly, the legal requirement for
companies to disclose in their published financial statements the number and cost of
all common shares repurchased during the year means that accurate measures of share
repurchase activity are readily available. In contrast, studies of U.S. buybacks are
forced to rely on potentially noisy estimates of share reacquisitions (e.g., Kahle, 2002;
Fenn and Liang, 2001; Dittmar 2000; Stephens and Weisbach 1998).
3
The remainder of the paper is organised as follows. The next section
summarises the extant literature on share repurchases. In section 3 we develop our
predictions regarding the drivers of U.K. repurchase activity and outline our research
design. Section 4 presents details of the sample and data, together with an analysis of
the reasons cited by management for share buybacks. The factors that distinguish
repurchasers from nonrepurchasers and those that explain the amount spent on
repurchases are examined in section 5. Section 6 concludes.
2. LITERATURE REVIEW
The literature on share repurchases can be classified according to two distinct
research methodologies: studies examining the market reaction to the announcement
of intentions to implement a repurchase programme and studies examining the actual
number and cost of shares bought back. The majority of extant studies adopt the
former approach. A consistent finding emerging from this body of work is that the
U.S. stock market reacts favourably to share repurchase announcements, with average
announcement-period abnormal returns ranging from 2% to 3.5% (e.g., Barth &
Kasznik, 1999; Comment and Jarrell, 1991; Lakonishok & Vermaelen, 1990;
Vermaelen, 1981). Positive market reactions to repurchase intention announcements
have also been documented for Canada (Ikenberry et al., 2000) and the U.K. (Oswald
and Young 2002a; Rau and Vermaelen, 2002).
A range of theories have been proposed and tested to explain the positive stock
market reaction to repurchase announcements. One explanation that has received
considerable attention in the literature is the signalling hypothesis. Information
asymmetry between managers and shareholders may cause a firm to be undervalued.
If insiders believe that their firm is undervalued, they may announce their intention to
4
implement a share repurchase programme to signal this fact to the market. The
signalling hypothesis predicts that market participants interpret share repurchase
announcements as evidence that the firm is underpriced, thus leading to an upward
revision in the share price (Comment and Jarrell, 1991; Vermaelen, 1981). Further,
because the likelihood of undervaluation is increasing in the level information
asymmetry, Barth and Kasznik (1999) predict and find evidence that both the
likelihood of a repurchase announcement and the resulting announcement-period
abnormal returns are positively associated with the level of information asymmetry.
An alternative explanation for the positive stock market reaction to repurchase
plan announcements is the surplus cash hypothesis which is based on the view that a
firm’s cash resources may exceed the set of value-increasing investment opportunities
available to management. Under such conditions, managers face incentives to invest
‘surplus’ cash on perquisites, empire building and other negative net present value
projects. Accordingly, shareholders of firms characterised by surplus cash and a poor
portfolio of investment opportunities face serious agency problems if management do
not distribute this excess cash (Harford, 1999; Jensen, 1986). Share repurchases
provide managers with a means of distributing excess cash to shareholders, thereby
reducing the opportunity for wasteful investment and hence increasing firm value.
Consistent with the surplus cash hypothesis, Lie (2000) reports a higher market
reaction to announcements of self-tender offers for firms with high cash holdings and
limited investment opportunities while Barth and Kasznik (1999) present evidence
that firms announcing open market share repurchase intentions are characterised by
larger cash holdings than nonannouncing firms.1
Open market repurchase plan announcements do not represent binding
commitments to repurchase shares in the future. Instead, firms are free to abandon the
5
proposed buyback at any subsequent stage, as well as deciding to repurchase more
shares than indicated in the original programme announcement. This feature raises
several concerns about using repurchase announcements to explore the motives for
share buybacks. First, studies relying on share repurchase announcements may
represent noisy tests of actual buyback activity.2 Second, to the extent that agency
costs are only reduced when a repurchase actually takes place, announcement-based
studies do not sit comfortably with the surplus cash hypothesis. Third, the costless
nature of open market repurchase announcements is inconsistent with the signalling
hypothesis, which is based on the assumption that buyback announcements are costly
signals to replicate. Fourth, several additional motives for share repurchases have
been proposed that are not necessarily expected to increase share prices at the
announcement date. These include fending off hostile takeover attempts, avoiding the
dilutive impact of share options on the per share value of outstanding stock and
adjusting the firm’s capital structure. For these reasons, recent work has begun to
focus on the aggregate number and cost of shares actually reacquired (e.g., Fenn and
Liang, 2001; Dittmar, 2000; Ikenberry et al., 2000; Stephens and Weisbach, 1998).
Oswald and Young (2002a), Ikenberry et al. (2000), Dittmar (2000) and
Stephens and Weisbach (1998) present evidence that share reacquisitions are
negatively correlated with share price performance: as prices fall, managers appear to
respond by buying more shares. This strategic trading behaviour is consistent with the
view that firms initiate repurchases when their shares are perceived as being
underpriced. As Rau and Vermaelen (2002: 250) discuss, the underpricing hypothesis
is subtly different from the signalling hypothesis because it assumes that the market’s
response to the announcement of a planned repurchase is incomplete. Consistent with
the incomplete adjustment assumption underlying the underpricing hypothesis,
6
Ikenberry et al. (1995) report positive abnormal returns for value stocks over the four-
year period following repurchase announcements.
In addition to underpricing, several studies present evidence consistent with
the prediction that share reacquisitions are motivated by a desire to distribute surplus
capital. For example, Jagannathan et al. (2000) and Stephens and Weisbach (1998)
report a positive association between share reacquisitions and cash flows, while
Dittmar (2000) documents a positive relation between reacquisitions and total cash
holdings. Further, because excess cash is most likely a problem for firms with limited
investment opportunities, Dittmar (2000) predicts and finds a strong negative
association between share reacquisitions and firms’ investment opportunity set, as
proxied by the market-to-book ratio.
While the surplus cash and underpricing hypotheses are the most prominent
explanations in the literature for share reacquisitions, other motives have also been
proposed and tested. The capital structure hypothesis predicts that repurchases are
motivated by the desire to maintain an efficient balance sheet (Dittmar, 2000). For
example, if managers believe that an optimal leverage ratio exists, repurchases may be
used by undergeared firms as a means of achieving their target leverage ratio.
Consistent with this prediction, Dittmar (2000) finds that share repurchases are
negatively associated with gearing. Moreover, if share reacquisitions are financed
with debt, they can help reduce corporate taxes and hence lower the firm’s cost of
capital (Rau and Vermaelen, 2002). However, an alternative explanation for the
negative association between share reacquisitions and leverage is that binding debt
contracts or an increased risk of financial distress may restrict the opportunity for
highly geared firms to implement buybacks.
7
Because repurchases increase the minimum price at which shares can be
purchased in the market, buybacks can be used as a part of a takeover defence strategy
designed to increase the price an acquirer will have to pay to gain control (Bagwell,
1991). Alternatively, Kahle (2002) and Barth and Kasznik (1999) cite the desire to
counter the dilutive effects of share options as an alternative motive for share
reacquisitions. Consistent with the takeover deterrence and share option hypotheses,
Dittmar (2000) reports that share reacquisitions by U.S. firms are positively associated
with both takeover likelihood and the total number of share options outstanding.
However, these associations are time-varying: the relation with takeovers is limited to
mid-1980s when the market for corporate control was at its peak while the link with
options is confined to the 1980s and 1990s when option-based compensation became
increasingly popular. Kahle (2002) provides additional evidence that firms repurchase
shares to fund employee option exercises and hence avoid earnings dilution.
3. RESEARCH DESIGN AND PREDICTIONS
This study examines share reacquisitions made by U.K. firms. We employ two
complementary approaches to isolate the drivers of actual share reacquisition activity.
First, we compare firms that make open market share reacquisitions with a control
sample of nonrepurchasing firms. Secondly, we model the value of shares repurchased
in a given year using the set of firms reporting at least one open market share
reacquisition during our sample period. Further details of these tests and their
associated predictions are outlined below.
What factors distinguish repurchasers from nonrepurchasers?
Our first set of tests involve comparing open market share repurchasers with a
time-, industry- and size-matched sample of nonrepurchasing firms. Specifically, we
8
estimate the following conditional logistic regression model relating the probability of
an open market share repurchase in time t to measures of underpricing, surplus cash,
investment opportunities, leverage and a vector of control variables:3
.
)Pr(
1,91,81,71,6
1,51,41,31,21,1,
−−−−
−−−−−
++++
∆++++=
titititi
titititititi
DISTSIZEDIVPAYLOSS
EPSHILEVCASHMTBNRETurchaseRep
γγγγ
γγγγγ (1)
All explanatory variables in equation (1) are measured at the beginning of the
repurchase year. The conditional logistic model is the appropriate method for matched
pairs data (Breslow, 1982). It involves fitting a standard logistic regression to a
constant response, where the model has no intercept and all explanatory variables are
equal to the difference between each case–control matched pair. Accordingly, the
dependent variable in equation (1) takes the value of one for each of the 365 matched
pairs in our sample while all explanatory variables are defined as the difference
between the ith pairwise combination. For simplicity, the following discussion refers
to all explanatory variables prior to differencing.
NRET is our proxy for underpricing and is defined as one if the market-
adjusted return measured over the fiscal year prior to the repurchase year is negative
and zero otherwise.4 Dittmar (2000) argues that a poor returns history is a possible
indicator of underpricing. Consistent with this prediction, Ikenberry et al. (1995),
Comment and Jarrell (1991) and Vermaelen (1981) document negative abnormal
returns in the months preceding a repurchase announcement, while Ikenberry et al.
(2000) and Stephens and Weisbach (1998) find that share reacquisitions and prior
stock returns are negatively associated. We predict that NRET will be negatively
associated with the likelihood that a firm repurchases its shares.5
9
MTB is the unlevered market-to-book ratio. It is predicted to be negatively
associated with the probability of a share repurchase for several reasons. First, firms
with low market-to-book ratios are more likely to be underpriced (Dittmar, 2000;
Ikenberry et al., 1995; Lakonishok et al., 1994). Secondly, to the extent that the
market-to-book ratio is negatively correlated with firms’ investment opportunities, the
agency problems of excess cash are likely to be more acute for low market-to-book
firms (Fenn and Liang, 2001; Lie, 2000; Lang and Litzenberger, 1989). However,
prior research also uses the market-to-book ratio as a proxy for information
asymmetry. According to this view, the probability of a share repurchase is expected
to be positively associated with MTB because high market-to-book firms are
predicted to face greater information asymmetry (Barth and Kasznik, 1999). The
information asymmetry effect confounds the negative association between MTB and
the likelihood of a buyback predicted by the underpricing and surplus cash hypotheses
and could, if strong enough, result in MTB being positively associated with
repurchase likelihood. The precise nature of the association between share repurchase
activity and the market-to-book ratio is therefore an empirical issue on which this
paper aims to shed light.
We include CASH in equation (1) as a direct measure of surplus cash. We
define CASH as the ratio of cash and cash equivalents to total assets. The surplus cash
hypothesis predicts that CASH will be positively associated with the likelihood of a
share repurchase. Equation (1) also includes HILEV, an indicator variable defined as
one if leverage is above the median for the pooled sample and zero otherwise. If firms
initiate buybacks when gearing levels undershoot their target leverage ratio, HILEV
will be negatively associated with the likelihood of a share repurchase. To control for
the negative association between leverage and excess cash we follow Dittmar (2000)
10
and measure gearing as the ratio of net debt (debt minus cash and cash equivalents) to
non-cash assets.
Equation (1) also includes several control variables. Analysis of management
disclosures (see Section 4) reveals that many firms in our sample cite the desire to
increase earnings per share (EPS) as a motivation for the repurchase. One explanation
for the concern with EPS is that managers believe analysts and investors fixate on
EPS growth for valuation purposes (The Times, January 10 1998: 53). We therefore
include a measure of earnings per share growth (∆EPS) in equation (1). However, we
do not predict the sign of the relation between ∆EPS and repurchase likelihood. On
the one hand, if firms with poor prior-period EPS performance are using share
repurchases in an attempt to boost (or signal an increase in) future EPS, ∆EPS will be
negatively associated with the likelihood of a repurchase. Alternatively, if firms with
high EPS growth in prior-periods are using repurchases as a means of sustaining (or
signalling) further growth in the future, ∆EPS will be positively associated with the
likelihood of a repurchase.
LOSS is an indicator variable taking the value of one if prior-year reported
earnings are negative and zero otherwise and is intended to proxy for the absence of
surplus advance corporation tax (ACT) against which to offset the ACT arising on a
share repurchase.6 All else equal, firms lacking surplus ACT capacity are less likely to
initiate a share repurchase because doing so will generate an additional ACT liability.
We therefore predict that LOSS will be negatively related to the probability of a share
repurchase. The dividend payout ratio (DIVPAY) is included to control for the
possible interaction between dividends and share repurchases. DIVPAY is defined as
dividends paid divided by reported earnings.7 We do not predict the sign of the
coefficient on DIVPAY because if firms view dividends and share repurchases as
11
substitutes the relation will be negative whereas if firms use both devices as
complimentary distribution mechanisms it will be positive. Firm size (SIZE) is
included to control for any residual size differences not captured by our matching
procedure. SIZE is measured as the natural log of total assets. Finally, DIST is an
indicator variable proxying for the existence of distributable reserves. Under U.K.
company law, firms are only allowed to fund share repurchases out of distributable
reserves. We define DIST as one if total shareholder reserves are positive and zero
otherwise and predict that this variable will be positively associated with the
probability of a share repurchase.
While prior studies have examined the independent effect of factors such as
underpricing, surplus cash and leverage on the reacquisition decision, the interaction
between these effects has been largely overlooked. Nevertheless, such interactions are
expected to play a potentially important role in explaining repurchase decisions. For
example, regardless of the specific driving force underlying the decision to repurchase
its shares, management are more likely to make reacquisitions when their stock
appears ‘cheap’, all else equal. In other words, even if underpricing is not the primary
driver of share reacquisitions, it may still play an indirect role through its impact on
buyback timing. Consistent with this view, Lie (2000) presents evidence that the
market reaction to repurchase plan announcements is larger for firms with surplus
cash holdings when their share price appears undervalued.8 To capture this effect, we
extend equation (1) to include the CASH×NRET interaction term and test whether it
is positively related to the likelihood of a share reacquisition.
In addition to its interaction with underpricing, surplus cash may also interact
with the investment opportunity set and gearing. Specifically, to the extent that the
surplus cash hypothesis represents the joint test that firms have high cash holdings and
12
a shortage of profitable investment opportunities, the likelihood of a firm reacquiring
shares to distribute excess cash is expected to increase as the availability of alternative
investment opportunities declines. Results reported by Fenn and Liang (20001) and
Lie (2000) support the prediction that the association between cash payouts and cash
holdings is stronger for firms with limited investment opportunities. Similarly, since
repurchases increase leverage, the likelihood of a firm reacquiring shares to distribute
excess cash is expected to be lower for firms that are already highly geared. This is
because further increases in leverage resulting from the repurchase could increase the
probability of financial distress. Based on the above arguments, we further expand
equation (1) to include the CASH×MTB and CASH×HILEV interaction terms. We
predict that both two-way interaction terms will be negatively associated with the
probability of a share reacquisition.
What factors explain the amount spent on repurchases?
As an alternative way of shedding light on the drivers of share repurchases we
model the amount firms spend on buybacks in each year during our sample window.
To the extent that each firm serves as its own control, this approach helps to overcome
the correlated omitted variable problem that can render the results of matched-pair
tests potentially difficult to interpret. In addition, the amount spent on buybacks
contains important information ignored by our matched-pairs tests. Accordingly, we
estimate the following OLS regression using an unbalanced panel comprising all
available firm-year observations for firms making at least one open market share
repurchase during our sample period:
.
)ln(
,,101,91,81,71,6
1,51,41,31,2,10,
tjtjtjtjtjtj
tjtjtjtjtjtj
ACTPAYOUTDISTLOSSEPS
HILEVCASHMTBNRETNRETCOST
εδδδδδ
δδδδδδ
+++++∆+
+++++=
−−−−
−−−−
(2)
13
COST is equal to zero for the jth firm in years where no shares are acquired;
otherwise it equals the aggregate cost of shares repurchased during fiscal year t scaled
by total assets at the beginning of year t. Because COST is lower bounded at zero, we
employ a logarithmic transformation to limit the risk of specification bias.9 The vector
of explanatory variables is identical to that in equation (1) with two exceptions. First,
we include a measure of contemporaneous share price performance (NRETt) in
equation (2) as a more timely underpricing proxy for firms that acquire shares towards
the end year t. Secondly, Oswald and Young (2002b) document a dramatic increase in
buyback activity following the abolition of ACT in April 1999. We therefore include
the indicator variable ACT in equation (2) to control for structural shifts in the level of
repurchase activity over time. ACT takes the value of one for financial years ending
on or after April 1999 and zero otherwise.
In addition to examining the independent impact of underpricing, investment
opportunities, surplus cash and leverage on the share reacquisition decision, we follow
our analysis of repurchasing and nonrepurchasing firms by expanding equation (2) to
include the two-way interaction terms CASH×NRET, CASH×MTB and
CASH×HILEV. Consistent with our matched-pairs tests, we expect the CASH×MTB
and CASH×HILEV interaction terms to be negatively associated with ln(COST)
while the CASH×NRETt and CASH×NRETt-1 terms are expected to be positively
associated with ln(COST).
4. SAMPLE, DATA AND DESCRIPTIVE STATISTICS
Sample selection
U.K. firms are required to disclose details of all shares repurchased during the
fiscal year in their published financial statements. We use these disclosures to identify
14
open market share reacquisitions made by U.K.-domiciled firms listed on the London
Stock Exchange (exclusive of closed-end investment trusts). In the absence of reliable
machine-readable data on the volume and value of share buybacks, two
complimentary procedures are used to isolate potential repurchasers. First, we identify
firms with at least one share repurchase-related news event between 1 January 1995
and 31 December 2000. Repurchase news events are obtained from a variety of
sources including the Securities Data Corporation Mergers and Corporate
Transactions database (via Thompson Financial), the London Stock Exchange
Regulatory News Service (via Sequencer) and The Financial Times. Our sample
period begins in January 1995 since this was the earliest date that news
announcements were available on the Sequencer database. After screening the initial
set of events to remove non-U.K.-domiciled firms, non-listed firms and closed-end
investment trusts, we are left with a sample of 3,476 announcements relating to 456
firms.10 Secondly, we isolate all U.K.-domiciled firms in the Datastream alive and
dead stocks files that report at least one negative value for item #1101 (Net Capital
Issues) during our sample period but which are not included in our event sample. This
procedure results in an additional 32 firms. Combining these with our set of event
firms yields in a final sample of 488 potential repurchasing firms.
We examine all financial statements (via Global Access) with year-ends
between 1 January 1995 and 31 December 2000 for each firm in the potential
repurchasers sample to identify actual share reacquisitions. For all firm-years where
an open market repurchase is identified, we record the aggregate number, percentage
and cost of shares reacquired. Our final sample consists of 429 firm-year repurchases
made by 251 firms: 126 firms make reacquisitions in a single fiscal year during the
15
sample window, 85 firms make reacquisitions in two years and 40 firms make
reacquisitions in three or more years.
To identify our control sample of nonrepurchasing firms, we employ a
matched-pairs design whereby each of the 429 repurchasing firm-years are twinned
with a time-, industry- and size-matched nonrepurchasing firm using the following
procedure:
(a) Measure total assets employed (Datastream item #391) of the repurchasing
firm at the beginning of the fiscal year in which shares are repurchased;
(b) Identify all firms on the alive and dead stocks files in the same Datastream
level-6 industry group as the repurchasing firm with non-missing total assets
employed data for the same calendar year and which are not included in our
original sample of potential repurchasers;
(c) Select the firm that minimises the absolute difference in total assets employed,
subject to this difference not exceeding ±25% of the corresponding figure for
the repurchasing firm. In the event that this condition is not met, repeat steps
(b) and (c) using the Datastream level-4 industry classification. In the event
that the size condition is also exceeded at level-4, select the firm (level-4 or
level-6 industry group) that minimises the absolute difference in total assets
employed;
(d) Search the published financial statements of the selected firm to ensure that no
shares were repurchased during the five-year period centred on the matching
year. In the event that this condition is not met, repeat steps (b) and (c) using
the next best match available.
In 27 cases (6%), an appropriate match cannot be identified. This reduces the useable
matched sample to 402 matched-pairs.11 Of these cases, 314 (88) are matched with a
16
control firm at industry level-6 (level-4). The ±25% size criterion is met in 328 cases
(82%).
In addition to comparing repurchasers with their nonrepurchasing
counterparts, our analysis also involves modelling the cost of share repurchases for
firms that bought back shares in at least one year during our sample period.
Accordingly, we construct an unbalanced panel based on the 251 repurchasing firms,
consisting of all available fiscal years during the sample window (regardless of
whether or not a repurchase occurred in a given year). For firm-years where no shares
are acquired the value (fraction) of shares repurchased is equal to zero, otherwise it is
equal to the aggregate cost (fraction) of shares bought.
Financial statement and market data required to compute our test variables are
collected from Datastream. Unless otherwise indicated, all explanatory variables are
measured at the year-end immediately prior to the repurchase (nonrepurchase) year.
Missing financial statement data reduce our initial sample of 402 matched-pairs to
365 useable pairwise observations. The unbalanced panel based on our buyback
sample consists of 1,243 firm-year observations with data for all explanatory
variables, of which 393 firm-years (32%) are characterised by a repurchase.
Descriptive statistics
Table 1 reports descriptive statistics for our initial sample of 429 firm-year
open market share repurchases: panel A reports repurchases by value while panel B
reports the number of shares repurchased as a fraction of beginning-of-period shares
outstanding. The aggregate value of shares repurchased during our sample window is
almost £22 billion, with the average (median) deal worth £50.9 million (£2.7 million).
The 12-month aggregate amount of shares bought in the average open market
17
buyback is almost 5% of beginning-of-period shares outstanding. A striking feature of
the results reported in table 1 is the dramatic growth in buyback activity during the
sample period. For example, the number of firms repurchasing their shares in the open
market increased almost fivefold from 26 in 1995 to 120 in 2000. In addition to an
increase in the frequency of buybacks, both the value and fraction of shares
repurchased in the average deal also increased substantially: in 2000 the mean
(median) buyback cost £65.3 million (£4 million) compared with only £40.3 million
(£1.3 million) in 1995. Oswald and Young (2002b) attribute part of this increase in
buyback activity to changes in taxation, most notably the abolition of dividend tax
credits in July 1997 and the abolition of ACT in April 1999.
Table 2 presents descriptive statistics for the variables used in our subsequent
tests. Results are reported separately for the full sample of repurchasing firms with
data available from Datastream and for the repurchaser and nonrepurchaser matched
samples. Variables are measured at the beginning of the repurchase year unless
otherwise indicated. Relative to the matched control sample, repurchasing firms are
characterised by larger cash holdings, more distributable reserves and lower leverage.
In addition, the median dividend payout ratio and the mean EPS growth are
significantly higher for the repurchaser sample. Finally, despite our matching
procedure, the median repurchasing firm is significantly larger than its
nonrepurchasing counterpart.
The distribution of reacquiring firms by industrial sector is reported in table 3.
Our sample is characterised by significant industry clustering, with 34% of
repurchasing firms located in just three industries (Construction and Building,
Engineering and Real Estate). Further analysis reveals that this clustering does not
simply reflect characteristics of the Datastream population. Firms from the
18
Construction and Building, Electricity, Engineering and Real Estate sectors are
overrepresented in our sample relative to the Datastream population. In contrast, firms
from the Investments and Software sectors are underrepresented in our sample. These
findings suggest that industry-related factors may play an important role in explaining
share repurchase decisions.
Repurchase reasons disclosed by management
To gain preliminary insight into the drivers of open market share repurchases
we analyse the reasons cited by management for the buyback. Management’s stated
repurchase motives are collected from published annual reports and financial
statements, together with news announcements made to the London Stock Exchange
and reported in the financial press. Our findings are reported in table 4. Despite the
Listing Rules of the London Stock Exchange requiring companies to disclose the
reason(s) for a share repurchase, a large fraction of our sample (26%) failed to cite
any clear motive (beyond a bland statement indicating that the repurchase was
earnings enhancing). Of the remaining cases, several of the motives developed and
tested by extant research figure prominently. For example, paying-out surplus cash is
cited in 11% of cases, with the desire to distribute disposal proceeds cited in a further
5% of cases. Similarly, the desire to increase balance sheet efficiency is cited by
management as a reason for the repurchase in 14% of cases. We interpret such
statements as either further evidence consistent with the surplus cash hypothesis or as
evidence of firms attempting to achieve a target leverage ratio. More disturbing from
a theoretical perspective is the 5% of cases where a reduction in the cost of capital is
cited as a motive for the repurchase.12 Finally, management also cite underpricing
amongst their list of repurchase reasons.
19
Contrary to extant research however, the most frequently cited motive for an
open market share repurchase (29% of cases) is the desire to increase current and
future earnings per share (EPS). Precisely what firms mean here is unclear. One
interpretation is that managers fixate on earnings and believe that reported
performance can be boosted simply by reducing the magnitude of the denominator in
the EPS calculation. Of course, to the extent that reducing the capital base results in
lower earnings capability, such logic appears flawed. A more charitable interpretation
is that the stated aim of increasing current and future EPS represents managerial
shorthand for improving operating efficiency by paying-out excess funds whilst
maintaining the same level of earnings. As such, these statements are consistent with
both the signalling and surplus cash hypotheses.
In summary, management cite a variety of motives for open market share
repurchases, some of which accord with extant finance theory and some of which do
not. In addition, several reasons such as increasing EPS and creating a more efficient
balance sheet are difficult to decode because a number of alternative interpretations
are possible. We attempt to shed further light on the determinants of share buybacks
in the following section by examining the characteristics of repurchasing firms.
5. RESULTS
Distinguishing repurchasers from nonrepurchasers
Coefficient estimates and model summary statistics from conditional logistic
regressions relating the probability of a share reacquisition to measures of
underpricing, investment opportunities, surplus cash, leverage and a vector of control
variables are reported in table 5. In model 1, NRET is positive and significant at the
0.001 level as predicted, indicating that repurchasing firms are more likely to
20
underperform their nonrepurchasing counterparts over the 12-month period prior to
the repurchase year. In contrast, repurchasing firms are statistically indistinguishable
from their nonrepurchasing counterparts in terms of the market-to-book ratio (MTB).
The estimated coefficient on CASH is positive and significant at the 0.02 level. This
supports the prediction that repurchases are more likely to be used by firms with high
cash holdings. In addition, repurchasing firms are characterised by significantly lower
leverage, as indicated by the negative and significant coefficient estimate on the
HILEV term. This is consistent with Dittmar’s (2000) conjecture that firms use share
repurchases to manage their capital structure when the leverage ratio falls below its
target level. However, it is also consistent with the increased risk of financial distress
preventing highly geared firms from reacquiring their shares.
Analysis of the implied probabilities from model 1 suggests that NRET,
CASH and HILEV also have an economically significant impact on the likelihood of
a share repurchase. Holding all other factors constant, the implied probability of a
firm with negative market-adjusted returns making a share repurchase is almost 23%
higher than a firm with positive market-adjusted returns. Similarly, the repurchase
likelihood for undergeared firms is 36% higher than for firms whose gearing is above
the sample median, while an interquartile range increase in cash holdings raises the
implied probability of a repurchase by 13%.
The findings reported for model 1 are robust to inclusion of the vector of
control variables included (model 2). The estimated coefficient on the earnings per
share growth term (∆EPS) is positive and marginally significant (p = 0.12). This
provides weak evidence that firms with high EPS growth in prior-periods are more
likely to repurchase their shares. Of the remaining four control variables, the
estimated coefficients on SIZE and DIST are positive and significant at the 0.05 level,
21
suggesting that relative to nonrepurchasers, repurchasing firms are larger and have
more distributable profits, respectively. In contrast, the coefficient estimates on the
LOSS and PAYOUT terms do not attain significance at conventional levels.
Models 3–6 examine two-way interactions between several of our key test
variables. Model 3 includes the interaction between CASH and NRET. Similar to
models 1 and 2, the CASH main effect term continues to be positive and significant,
indicating that the probability of a repurchase increases in the level of cash holdings
for firms with above-market performance. However, the magnitude of the coefficient
estimate on CASH is more than double the corresponding values reported in models 1
and 2, indicating that the surplus cash effect is particularly strong in the absence of
poor prior-period performance: an increase in cash holdings from the first to the third
quartile increases the implied probability of a repurchase by 32% for firms
characterised by above-market performance. In addition, the NRET main effect also
becomes more pronounced in model 3 following inclusion of the interaction term.
Contrary to predictions, however, the CASH×NRET coefficient estimate is negative
and significant, indicating that the excess cash effect is significantly lower for
underperforming firms. Indeed, the coefficient on CASH is indistinguishable from
zero for underpriced firms (estimated coefficient = 0.599 [4.315 – 3.716]; p-value =
0.902). These findings suggest that the decision to distribute surplus cash via a share
repurchase is contingent on the absence of prior-period underperformance. In the
presence of perceived underpricing, firms with high cash holdings actually appear less
likely to repurchase their shares (estimated coefficient = –2.847 [0.869 – 3.716]; p-
value = 0.114).
In model 4 we examine interaction between CASH and MTB. The estimated
coefficient on the CASH×MTB term is indistinguishable from zero. Further, neither
22
the CASH nor MTB main effect coefficient estimates differ in any meaningful sense
from those reported in models 1 and 2. To the extent that the market-to-book ratio
captures aspects of the investment opportunity set, these results do not support the
view that firms with few investment opportunities are more likely to distribute cash
via a share repurchase. One possible explanation for this null result is that our
matched-pairs design lacks power. Specifically, our matched-pairs approach may have
controlled-out important inter-industry differences in investment opportunities. We
return to this issue in subsequent sections.
Model 5 examines the interaction between cash holdings and leverage. From a
surplus cash perspective, share repurchases are less likely to be used to disgorge cash
if the resulting buyback causes the gearing ratio to become excessively high, thereby
increasing the likelihood of debt covenant violation. This leads to the prediction that
the positive association between cash and the likelihood of a repurchase will be more
pronounced for firms with low leverage. The results reported for model 5 are
consistent with this prediction. The CASH×HILEV interaction term is negative and
significant at the 0.1 level. For firms with net leverage below the sample median, the
probability of a repurchase is increasing in the level of surplus cash (coefficient
estimate = 2.519; p-value = 0.01). In contrast, there is no link between cash holdings
and repurchase likelihood for firms whose net debt is above the sample median
(coefficient estimate = 0.542 [2.519 – 3.061]; p-value = 0.863).
While the coefficient estimate for the CASH main effect term continues to be
positive and significant, HILEV is rendered insignificant in model 5 following
inclusion of the cash-leverage interaction term. Rather, the significant negative
association between HILEV and the likelihood of a share repurchase is confined to
firms with high cash holdings (estimated coefficient = –3.244 [–3.061 – 0.183]; p-
23
value = 0.077). These findings are inconsistent with the optimal leverage hypothesis,
which predicts that firms initiate share repurchases whenever gearing falls below
target regardless of the level of cash holdings. Instead, our results suggest that gearing
affects the repurchase decision only indirectly via its intervening effect on the
association between repurchase likelihood and surplus cash.
Model 6 in table 5 is the full model, comprising all main effect and two-way
interaction terms. The results are qualitatively identical to those reported in models 3–
5. Specifically, of our test variables, NRET and CASH emerge as the dominant
factors affecting the likelihood of a share repurchase. In addition, CASH appears to
interact with both prior-period share price performance and gearing in determining the
repurchase decision. While the negative estimated coefficient on the CASH×HILEV
interaction term accords with our predictions, the negative interaction between CASH
and NRET is contrary to the view that firms wishing to distribute excess cash are
more likely to do so in the presence of perceived underpricing.
Explaining the amount spent on repurchases
In this section we provide further evidence on the drivers of share
reacquisitions by estimating equation (2) on an unbalanced panel comprising all firm-
year observations between January 1995 and December 2000 for firms making at least
one open market share repurchase during this period. Coefficient estimates and
summary statistics for several versions of equation (2) are reported in table 6. In
model 1, the estimated coefficients on NRETt and NRETt-1 are positive as predicted
but only the lagged measure is significant at conventional levels. The coefficient
estimate on CASH is also positive and significant in model 1. These results, which are
consistent with those reported for the matched-pairs analysis in table 5, suggest that
24
prior-period market performance and cash holdings are important factors explaining
the amount spent on share repurchases. In addition, the market-to-book ratio is also
negative and significant in model 1. This provides further support for the underpricing
hypothesis. It is also consistent with the prediction that firms repurchase their shares
when alternative investment opportunities are scarce. In contrast, our results provide
no support for the prediction that share repurchases are a response to high information
asymmetry per se. Although the estimated coefficient on HILEV is negative as
predicted by the optimal leverage hypothesis, it is not significant at conventional
levels. These findings provide further support for the conclusion that share
repurchases and leverage are not directly related.
The positive coefficient on NRETt becomes significant at the 0.05 level in
model 2 following inclusion of the vector of control variables, indicating that in
addition to lagged underperformance, firms spend more on share repurchases when
contemporaneous performance is poor. Coefficient estimates on the remaining test
variables in model 2 remain broadly similar to those in model 1. Of the control
variables, LOSS and ACT are significant at the 0.05 level or better. The negative
coefficient on LOSS supports the prediction that the absence of surplus ACT in the
pre-April 1999 period acted as an important constraint on repurchase activity.
Consistent with this view, the amount spent on open market repurchases increased
dramatically following the abolition of ACT, as evidenced by the large positive
coefficient on the ACT indicator variable. The estimated coefficient on ∆EPS is
indistinguishable from zero, providing no support for the prediction that firms with
high prior-period EPS growth use share repurchases in an attempt to maintain such
growth in future periods.
25
In model 3 we extend equation (2) to include the two-way interactions
between cash holdings and our underpricing, market-to-book ratio and leverage
proxies. Coefficient estimates on the CASH and NRETt-1 main effect terms remain
robust to the inclusion of these interaction terms. In contrast, NRETt and MTB are no
longer significant at conventional levels. In addition, none of the two-way interaction
terms are significant. These results do not support the view that the level of cash
holdings interacts with either market-adjusted returns, the market-to-book ratio or
leverage in determining share repurchase activity. The insignificant coefficient
estimates on CASH×HILEV and CASH×NRETt-1 contrast with the matched-pairs
results reported in table 5.
Models 4 and 5 in table 6 repeat the previous analysis after trimming the
sample to remove the extreme top and bottom percentiles of each test variable. Whilst
the findings for model 4 are virtually identical to those reported for model 2 using the
full sample, the two-way interactions reported in model 5 are sensitive to the
exclusion of extreme values. Specifically, both the CASH×NRETt and CASH×MTB
interaction terms are significant at the 0.1 level following trimming. The positive
coefficient estimate on CASH×NRETt indicates that firms with high cash balances
make larger distributions to shareholders when contemporaneous market performance
is poor: the estimated coefficient on CASH is 28.317 (14.321 + 13.996; p-value =
0.042) when year t returns undershoot the market, compared with only 14.321 when
year t returns exceed the market. This supports the view that firms time distributions
of excess cash to take advantage of perceived undervaluation, thereby creating
additional value for shareholders. The negative coefficient on the CASH×MTB
interaction term also supports the timing hypothesis. However, it is also consistent
with the prediction that firms with high cash holdings and low investment
26
opportunities are more likely to use repurchases to distribute surplus cash to
shareholders: the estimated coefficient on CASH is 14.321 (p-value = 0.09) for low
market-to-book firms, compared with only 10.762 (14.321 – 3.559; p-value = 0.391)
for high market-to-book firms.
Investment opportunities: industry-level analysis
Theory suggests that share repurchases are a response to high cash holdings in
the presence of limited investment opportunities. Firms’ investment opportunities are
to a large extent determined by the industry in which they operate (Smith and Watts,
1992). Results presented in table 3 indicate significant industry clustering with respect
to share repurchase activity. However, tests reported in the previous sections focus
solely on explaining intra-industry variation in repurchase activity and as such provide
weak tests of the investment opportunity set hypothesis.
To shed further light on the link between share repurchases and investment
opportunities, we adopt an alternative testing procedure that better captures inter-
industry variation in buyback activity. Specifically, we estimate an industry-level
version of equation (2) where the dependent variable is the average amount spent on
share repurchases by all firms in industry k during calendar year t and all explanatory
variables are defined as their corresponding industry-year averages (measured at time
t-1). The model is estimated using all Datastream level-4 industry groups listed in
table 3 with available data and industry-year averages are computed using all
available firms on the Datastream alive and dead stocks files. The final dataset
consists of 225 industry-year observations for calendar years 1995 to 2000 (inclusive).
Summarised results are as follows (two-tailed p-values in parentheses):13
27
(0.04) (0.01) (0.84) (0.18) CASHMTB eCASH eMTB eeCOST tktktktktk 1,1,
61,
61,
66, 37.2085.2705..185.3 −−
−−
−−
−− ×−+−−=
Adjusted-R2 = 7.99%; F–statistic = 2.94
Average cash holdings are positively related to the amount spent on share repurchases
in industry k. While the estimated coefficient on the industry market-to-book ratio
main effect term is not significant, the interaction between MTB and CASH is
negative and significant, indicating that the positive association between buybacks
and cash holdings is lower in industries comprising high market-to-book firms.
Indeed, for high MTB industries, the association between repurchases and CASH is
indistinguishable from zero (coefficient estimate = 7.48e-6 [27.85e-6 – 20.37e-6]; p-
value = 0.65). Assuming that the market-to-book ratio captures elements of the
investment opportunity set, these findings lend further support to the prediction that
share repurchases are used more frequently when cash holdings are high and
investment opportunities are limited.
6. SUMMARY AND CONCLUSIONS
Once the sole domain of U.S. corporations, share repurchases are becoming an
increasingly common phenomenon among their U.K. counterparts. Between January
1995 and December 2000, we find that U.K. firms spent almost £22 billion on open
market share repurchases and recent reports in the financial press suggest that this
trend is set to continue. Further, the U.K. represents an interesting setting in which to
explore share repurchase activity because of the legal requirement for firms to report
the number and cost of share reacquisitions in their published financial statements.
This means that accurate measures of share repurchase activity are readily available in
the U.K. This contrasts with the situation in the U.S. where researchers are forced to
use proxies for the number and value of shares repurchased.
28
We begin by analysing the buyback reasons cited by management and find
that the desire to pay out surplus cash figures prominently. However, the reason most
frequently cited by U.K. managers (29% of cases) is the desire to increase earnings
per share. Precisely what is meant by such a statement is unclear: on the one hand it
may suggest that managers fixate on earnings per share growth and believe that
reported performance can be enhanced simply by reducing the magnitude of the
denominator in the EPS calculation; on the other it may be managerial shorthand for
improving operating efficiency by paying-out excess funds whilst maintaining the
same earnings capability. Other frequently cited motives such as increasing balance
sheet efficiency are equally difficult to decode. Given the ambiguity associated with
such statements, coupled with the fact that over half of our sample failed to disclose
any motive for the buyback, we examine the characteristics of repurchasing firms as
an indirect means of shedding further light on the determinants of share buybacks.
Comparing repurchasing firms with a time-, industry- and size-matched
sample of nonrepurchasers reveals high cash holdings and poor prior-period share
price performance to be the key factors driving the repurchase decision. Similar
results emerge when we model the amount spent on repurchasing shares. These
findings are consistent with the view that share repurchases are a response to the
problems of surplus cash and perceived market underpricing, respectively. Our
underpricing results do not support Rau and Vermaelen’s (2002) conjecture that
regulatory restrictions in the U.K. prevent firms from using repurchases to exploit
perceived instances of market mispricing.
Additional tests reveal that the positive association between cash holdings and
the amount spent on share repurchases is stronger for firms with low market-to-book
ratios. To the extent that the problem of surplus cash are likely to be most acute when
29
investment opportunities are limited (i.e., low market-to-book firms), these results
provide further evidence that firms use repurchases as a means of mitigating the
agency problems of excess cash.
In contrast to Dittmar (2000), we find no evidence of a direct association
between repurchases and leverage. As such, our results do not support the view that
U.K. firms use share repurchases to manage their capital structure when gearing
undershoots some predetermined optimal level. However, further tests suggest that
gearing may affect the repurchase decision indirectly via its intervening effect on the
association between repurchase likelihood and surplus cash. Specifically, we find that
the positive association between repurchases and surplus cash is more pronounced
when gearing is low. We interpret these findings as evidence that the increased risk of
financial distress constrains the ability of already highly geared firms to distribute
surplus cash via a share repurchase.
30
NOTES 1 However, Barth and Kasznik (1999) report a negative association between announcement-
period returns and surplus cash. Their results contrast with those reported by Lie (2000) and
suggests that rather than viewing repurchases as a cure for agency problems associated with
surplus cash, market participants view the distribution of surplus cash as bad news because it
indicates a lack of available positive net present value projects. 2 Stephens and Weisbach (1998) study a sample of 450 open market share repurchase
announcements made by US firms and find that approximately one quarter of all shares
targeted at the time of the announcement remain unacquired at the end of the three-year
postannouncement period. Similarly, Ikenberry et al. (2000) report that over 95% of Canadian
repurchase announcers fail to fully complete their buybacks programmes, with approximately
one quarter of announcers failing to make any repurchases. 3 We do not consider the use of open market share reacquisitions as a takeover defense
mechanism because as Allen and Michaely (2002) discuss, such effects are likely to be
restricted to self-tender offers in which a large fraction of shares are bought over a short
period. In addition, we do not examine the association between share reacquisitions and the
level of share options outstanding because in contrast to the U.S. where reacquired shares can
be held as treasury stock for reissue in later periods, U.K. company law requires all
repurchased shares to be cancelled. The absence of the treasury stock option in the U.K.
increases the cost of using buybacks as a means of countering the dilutive effects of options.
4 Because our share reacquisition data are obtained from firms’ published financial statements
measured on an annual basis, share returns measured over fiscal year t-1 may represent a poor
(i.e., untimely) underpricing proxy for firms that acquire shares towards the end year t. We
addressed this issue in untabulated tests by including contemporaneous returns in equation (1)
as an additional explanatory variable. In no case, however, did this variable attain significance
at conventional levels.
5 Our prediction is based on the view that managers are more likely to perceive an
underpricing problem in the wake of a recent deterioration in share price. Whether in reality
price declines signal underpricing remains an unresolved issue (Brennan et al., 1998;
Jegadeesh and Titman, 1993; Chopra et al., 1992; DeBondt and Thaler, 1985). 6 Prior to the abolition of ACT in April 1999, open market share repurchases qualified as
distributions for tax purposes and as such generated an ACT charge. In the absence of surplus
ACT capacity against which to offset this charge, buybacks resulted in firms incurring an
additional tax liability. Accordingly, open market repurchases were relatively unattractive to
firms seeking to minimise their ACT liability (e.g., loss-making firms).
31
7 If reported earnings are negative but the firm still pays a dividend we set DIVPAY equal to
the ratio of dividends paid divided by six percent of total assets (Lee and Swaminathan,
1999). For nondividend firms paying firms with negative reported earnings we set DIVPAY
equal to zero.
8 As a specific example of the interaction between the surplus cash and underpricing
hypotheses, Oswald and Young (2002b) discuss how Barclays Plc appeared to exploit short-
term dips in its share price to create further value for non-selling shareholders during its £2.6
billion buyback programme aimed at disgorging excess cash.
9 To avoid generating missing values, we redefine COST as being equal to 10-9 in years where
no shares are acquired. In alternative specifications (not tabulated) we re-estimated equation
(2) after replacing ln(COST) with the percentage of shares repurchased. We estimated a
logistic version of equation (2) in which the dependent variable takes the value of one for a
repurchase year and zero otherwise. In both cases, the tenor of our results does not change.
10 We retain all firms with at least one news announcement, regardless of the specific nature
of the announcement. Announcements cover a wide spectrum of events including: proposals
to seek authority to repurchase shares at a forthcoming Annual or Extraordinary General
Meeting; confirmation that repurchase authority has been granted at a recent General
Meeting; plans to implement a specific buyback programme; plans to resume, continue with
or extend an existing repurchase plan; and notification of actual share reacquisitions.
11 The 27 nonmatching cases occur due to an absence of nonrepurchasing firms in the same
industry group (i.e., all firms in the industry either announced repurchase intentions or
implemented a buyback during the five-year period centred on the announcement year). The
nonmatching cases are drawn almost exclusively from the utilities sector. As a result, findings
based on the comparison of repurchasing and nonrepurchasing firms may not be
generaliseable to firms in the electricity and water industries.
12 Closer inspection of the relevant disclosures suggests that this is not a tax shield story.
Rather, managers appear to believe that a reduction in the cost of capital can be achieved by
replacing ‘expensive’ equity with ‘cheap’ debt. 13 The full model from which these summarized results are drawn is:
,,,11
1,10
1,91,81,7
1,
1,1,5
1,4
1,1,2
,0
,
tktktktk
tktktk
tktktktk3
tktki
tk
ACTPAYOUTDISTLOSSEPSHILEV
CASHMTBCASHMTB NRETNRETCOST
υωωωωωω
ωωωωωω
+++++∆++
×+++++=
−−−−
−
−−−−−
where ¯ indicates that variables are measured as the means for industries 1 to K at time t-1.
32
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Oswald, D. and S. Young (2002b), ‘Boom Time for Buybacks’, Accountancy, Vol.
130 (October), pp.52-53.
Rau, P. and T. Vermaelen (2002), ‘Regulation, Taxes and Share Repurchases in the
U.K.’, Journal of Business Vol. 75, pp.245-82.
Rees, W. (1996), ‘The Impact of Open Market Equity Repurchases on U.K. Equity
Prices’, European Journal of Finance, Vol. 2, pp. 353-370.
Stephens, C. and M. Weisbach (1998), ‘Actual Share Reacquisitions in Open Market
Repurchase Programs’, Journal of Finance, Vol. 53, pp.313-333.
Smith, C. and R. Watts (1992). ‘The Investment Opportunity Set and Corporate
Financing, Dividends and Compensation Policies’, Journal of Financial Economics,
Vol. 32, pp.263-292.
Vermaelen, T. (1981), ‘Common Stock Repurchases and Market Signalling: An
Empirical Study’, Journal of Financial Economics, Vol. 9, pp.139-83.
35
Table 1 Descriptive statistics for open market share reacquisitions made by U.K.-domiciled firms between January 1 1995 and December 31 2000. The sample is drawn from all firms with at least one repurchase announcement reported by either Sequencer, The Financial Times or the Securities Data Corporation during the sample period, plus all remaining firms in the Datastream alive and dead stocks files with at least one negative value for item #1101 (Net Capital Issues) during the same period. The final sample consists of 429 firm-year observations. Repurchase data are collected directly from firms’ published financial reports.
Panel A: Value of shares repurchased (£ million)
Year N Mean St. dev Q3 Median Q1 Sum 1995 26 40.319 103.407 35.300 1.254 0.275 1048.300 1996 42 63.446 156.308 21.235 2.238 0.227 2664.730 1997 49 53.646 116.070 25.400 3.068 0.441 2628.650 1998 87 35.219 108.705 11.701 2.000 0.648 3064.090 1999 105 43.648 144.412 15.300 2.600 0.704 4583.080 2000 120 65.321 205.770 30.908 3.951 1.1695 7838.540
All 429 50.880 154.385 21.000 2.675 0.648 21827.386
Panel B: Fraction of outstanding shares repurchased a
Year N Mean St. dev Q3 Median Q1 1995 26 0.045 0.041 0.079 0.032 0.011 1996 42 0.052 0.042 0.079 0.048 0.017 1997 49 0.046 0.058 0.055 0.028 0.010 1998 87 0.038 0.036 0.050 0.025 0.013 1999 105 0.047 0.053 0.060 0.029 0.014 2000 120 0.057 0.062 0.077 0.040 0.014
All 429 0.048 0.052 0.064 0.031 0.013
a Number of ordinary shares repurchased in the open market during the fiscal year as a fraction of total shares outstanding at the beginning of the year.
36
Tab
le 2
D
escr
iptiv
e st
atis
tics f
or v
aria
bles
use
d to
exp
lain
the
shar
e re
acqu
isiti
on d
ecis
ion.
The
repu
rcha
ser s
ampl
e co
nsis
ts o
f UK
-dom
icile
d fir
ms l
iste
d on
the
Lond
on S
tock
Exc
hang
e th
at m
ade
shar
e re
acqu
isiti
ons b
etw
een
Janu
ary
1 19
95 a
nd D
ecem
ber 3
1 20
00. S
hare
reac
quis
ition
s are
iden
tifie
d us
ing
anno
unce
men
ts re
porte
d by
The
Sec
uriti
es D
ata
Cor
pora
tion,
Seq
uenc
er a
nd T
he F
inan
cial
Tim
es, t
oget
her w
ith n
egat
ive
valu
es o
f Dat
astre
am it
em #
1101
(N
et C
apita
l Iss
ues)
. Whe
re p
ossi
ble,
repu
rcha
sers
are
mat
ched
with
a si
mila
r non
repu
rcha
sing
firm
on
the
basi
s of c
alen
dar y
ear,
indu
stry
and
size
.
M
atch
ed sa
mpl
e
Ope
n m
arke
t rep
urch
aser
s R
epur
chas
ers
Non
repu
rcha
sers
p-
valu
esb
Var
iabl
ea N
M
ean
St. d
evM
edia
n N
Mea
n St
. dev
M
edia
nN
M
ean
St. d
ev
Med
ian
t-tes
t W
ilcox
on
Exce
ss re
turn
t 41
1
-0.0
280.
488
-0.0
7936
1-0
.028
0.50
5 -0
.081
315
0.00
50.
628
-0.0
460.
051
0.01
2Ex
cess
retu
rn t-1
41
5
-0.0
980.
321
-0.1
3436
5-0
.111
0.32
0-0
.149
365
-0.0
810.
427
-0.1
090.
233
0.24
1M
arke
t-to-
book
ratio
t-1
413
1.68
21.
681
1.21
836
51.
709
1.76
11.
207
365
2.07
310
.105
1.22
90.
499
0.84
7C
ash
t-1
416
0.12
40.
142
0.07
436
50.
121
0.13
70.
072
365
0.09
10.
106
0.05
70.
001
0.00
2N
et le
vera
ge t-
1 41
60.
340
0.51
00.
398
365
0.35
40.
502
0.40
536
50.
453
0.33
60.
465
0.00
10.
001
EPS
grow
th t-
1 40
20.
350
3.95
60.
076
365
0.32
84.
136
0.06
636
5-0
.611
7.43
80.
107
0.03
50.
105
Rese
rves
t-1
416
0.30
30.
225
0.30
136
50.
300
0.22
20.
304
365
0.17
40.
364
0.19
90.
001
0.00
1Si
ze t-
1 (£
mill
ions
) 41
6 61
44.8
40
28
779.
000
16
0.18
7
365
5953
.200
289
41.5
00
15
5.50
9
365
5438
.320
2576
0.40
0
152.
803
0.
323
0.00
6 D
ivid
end
payo
ut ra
tio t-
1 41
60.
573
0.87
10.
428
365
0.57
40.
796
0.43
436
50.
876
4.47
40.
381
0.20
70.
003
a Var
iabl
e de
finiti
ons a
re a
s fol
low
s (D
atas
tream
item
s in
pare
nthe
ses)
: Exc
ess r
etur
n is
the
12-m
onth
mar
ket-a
djus
ted
shar
e re
turn
mea
sure
d ov
er fi
scal
yea
r t,
the
Mar
ket-t
o-bo
ok ra
tio is
de
fined
as t
he m
arke
t val
ue o
f equ
ity (H
MV
) plu
s the
boo
k va
lues
of p
refe
renc
e di
vide
nds (
306)
and
long
-term
deb
t (32
1) d
ivid
ed b
y ne
t tot
al a
sset
s (39
1), C
ash
is th
e ra
tio o
f cas
h an
d ca
sh
equi
vale
nts (
375)
to to
tal a
sset
s (39
2), N
et le
vera
ge is
tota
l cur
rent
liab
ilitie
s (39
8) p
lus l
ong-
term
deb
t (32
1) m
inus
cas
h an
d ca
sh e
quiv
alen
ts (3
75) d
ivid
ed b
y to
tal a
sset
s min
us c
ash
and
cash
eq
uiva
lent
s, EP
S gr
owth
is th
e ch
ange
in e
arni
ngs p
er sh
are
(625
/ N
S) sc
aled
by
the
abso
lute
val
ue o
f beg
inni
ng-o
f-pe
riod
earn
ings
per
shar
e, R
eser
ves i
s tot
al sh
areh
olde
rs’ r
eser
ves (
304)
sc
aled
by
tota
l ass
ets (
392)
, Siz
e is
tota
l ass
ets (
392)
, and
the
Div
iden
d pa
yout
ratio
is o
rdin
ary
divi
dend
s (18
7) d
ivid
ed b
y ea
rnin
gs fo
r ord
inar
y sh
areh
olde
rs (6
25).
For d
ivid
end
payi
ng fi
rms
with
neg
ativ
e ea
rnin
gs, t
he D
ivid
end
payo
ut ra
tio is
def
ined
as d
ivid
ends
pai
d di
vide
nd b
y si
x pe
rcen
t of t
otal
ass
ets.
For n
ondi
vide
nd p
ayin
g fir
ms w
ith n
egat
ive
earn
ings
, the
Div
iden
d pa
yout
ra
tio is
set e
qual
to z
ero.
Yea
r t is
the
fisca
l yea
r in
whi
ch a
shar
e re
purc
hase
occ
urre
d. Y
ear t
-1 is
the
fisca
l yea
r pre
cedi
ng th
e re
purc
hase
yea
r. b T
wo-
taile
d p-
valu
es fo
r mat
ched
-pai
rs te
sts o
f the
diff
eren
ce b
etw
een
repu
rcha
sing
and
non
repu
rcha
sing
firm
s.
37
Table 3 Industrial classification of U.K.-domiciled firms making open market share reacquisitions between January 1 1995 and December 31 2000. The sample is drawn from all firms with at least one repurchase announcement reported by either Sequencer, The Financial Times or the Securities Data Corporation during the sample period, plus all remaining firms in the Datastream alive and dead stocks files with at least one negative value for item #1101 (Net Capital Issues) during the same period. The final sample of 429 firm-year observations consists of 251 individual firms. Industry groups are based on the Datastream level-4 classification.
Universea Repurchasersb Universea Repurchasersb Industry group % N % Industry group % N % Aerospace 0.60 2 0.80 IT support 0.02 0 0.00 Automobiles & parts 0.94 2 0.80 Leisure & entertain. 6.14 13 5.18 Banks 1.11 6 2.39 Life assurance 0.43 1 0.40 Beverages 0.77 2 0.80 Media & photography 6.16 8 3.19 Chemicals 2.10 3 1.20 Mining 2.22 3 1.20 Construction & building 5.34 23 9.16* Off shore investment 0.36 0 0.00 Distributors 3.26 12 4.78 Oil & gas 2.46 4 2.39 Diversified industrials 0.89 0 0.00 Other business 4.18 2 0.80* Electricity (utilities) 1.28 13 5.18** Packaging 1.38 1 0.40 Electronics 5.10 9 3.59 Personal care 0.36 0 0.00 Engineering 5.48 25 9.96* Pharmaceuticals 1.64 2 0.80 Food & drug retailers 0.92 2 0.80 Real estate 5.92 38 15.14* Food producers 3.02 12 4.78 Retailers (general) 4.44 14 5.58 Forestry & paper 0.19 0 0.00 Software 4.78 3 1.20* Gas distribution 0.14 0 0.00 Speciality finance 4.42 8 3.19 Household goods 4.57 13 5.18 Steel 0.70 1 0.40 Healthcare 1.62 1 0.40 Support services 5.43 8 3.19 IT hardware 1.14 2 0.80 Telecommunications 1.09 0 0.00 Insurance support 0.17 0 0.00 Tobacco 0.19 1 0.40 Insurance 1.50 2 0.80 Transport 2.15 9 3.59 Investments 2.92 0 0.00* Water (utilities) 1.64 6 2.39
Total 251
a All Datastream firms in a given level-4 industry group as a percentage of the total population of Datastream firms (N = 4140). b All repurchasing firms in a given Datastream level-4 industry group as a percentage of all repurchasing firms (N = 266). * (**) Sample proportion differs from the universe proportion at the p < 0.05 (0.01) level based on a proportional Z-test (Newbold, 1988).
38
Table 4 Repurchase reasons disclosed by management. The sample consists of U.K.-domiciled firms making open market share reacquisitions between January 1 1995 and December 31 2000. Repurchase reasons are collected from firms’ published annual reports, together with announcements made to the London Stock Exchange and the financial press.
Reason disclosed in:
Annual report a Annual report or initial
announcement b Disclosed reason for buyback N % of firms c N % of firms c No reason 148 28.96 140 25.83 Increase earnings per share 148 28.96 155 28.60 Firm is undervalued 23 4.50 27 4.98 Increase balance sheet efficiency 73 14.29 77 14.21 Distribute excess cash 55 10.76 61 11.26 Defend against takeover 0 0.00 1 0.18 Distribute disposal proceeds 17 3.33 25 4.61 Reduce the cost of capital 23 4.50 25 4.61 Return of value 7 1.37 11 2.03 Other 17 3.33 20 3.69
Total 511 542
a Firms disclosing a given reason in their annual report. b Firms disclosing a given reason in either their annual report or in their initial buyback announcement. c Frequency of a given reason divided by total number of repurchasing firm-years (N = 429). Aggregate percentages exceed 100% because some firms disclose multiple reasons.
39
Table 5 Conditional logistic regressions relating the probability of an open market share reacquisition over the period January 1995 and December 2000 to measures of undervaluation, investment opportunities, cash holdings, gearing and a vector of control variables. Repurchasing firms are matched with a similar nonrepurchasing firm on the basis of calendar year, industry and size. The dependent variable in the conditional logistic models takes the value of one for each of the 365 matched pairs in our sample while all explanatory variables are defined as the pairwise difference between the ith repurchaser and its corresponding matched nonrepurchaser. Probability values (two-tailed) are reported in parentheses.
Model:a
1,91,81,71,6
1,51,41,31,21,1)Pr(
−−−−
−−−−−
++++
∆++++=
titititi
tititititii
DISTSIZEDIVPAYLOSS
EPSHILEVCASHMTBNRETurchaseRep
γγγγ
γγγγγ
Variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 NRETt-1 0.505 0.493 0.869 0.487 0.475 0.835 (0.004) (0.006) (0.000) (0.006) (0.008) (0.001) MTB -0.005 -0.003 -0.004 -0.010 -0.004 -0.011 (0.713) (0.791) (0.782) (0.653) (0.735) (0.622) CASH 1.879 1.754 4.315 1.508 2.519 4.797 (0.019) (0.029) (0.002) (0.085) (0.008) (0.003) HILEV -0.555 -0.458 -0.481 -0.456 -0.183 -0.210 (0.002) (0.012) (0.009) (0.012) (0.445) (0.386) CASH × NRETt-1 − − -3.716 − − -3.706 (0.022) (0.028) CASH × MTB − − − 0.100 − 0.095 (0.478) (0.490) CASH × HILEV − − − − -3.061 -2.965 (0.083) (0.098) ∆EPS − 0.026 0.026 0.026 0.027 0.027 (0.120) (0.131) (0.119) (0.108) (0.116) LOSS − -0.313 -0.371 -0.307 -0.334 -0.387 (0.313) (0.231) (0.323) (0.284) (0.214) PAYOUT − -0.052 -0.054 -0.052 -0.051 -0.053 (0.218) (0.213) (0.217) (0.215) (0.210) SIZE − 0.595 0.632 0.592 0.586 0.619 (0.031) (0.024) (0.031) (0.032) (0.025) DIST − 0.775 0.746 0.781 0.764 0.743 (0.018) (0.022) (0.017) (0.020) (0.024)
N 365 365 365 365 365 365 χ2 p-value b 0.001 0.001 0.001 0.001 0.001 0.001
Implied probability of repurchase announcement for top and bottom quartiles c Base case 0.522 0.534 0.533 0.535 0.549 0.549 NRET Top quartile 0.644 0.652 0.731 0.652 0.662 0.737 Bottom quartile 0.522 0.534 0.533 0.535 0.549 0.549 MTB Top quartile 0.520 0.533 0.532 0.533 0.548 0.546 Bottom quartile 0.522 0.534 0.533 0.536 0.549 0.549
40
Table 5 (continued) CASH Top quartile 0.550 0.560 0.598 0.558 0.587 0.620 Bottom quartile 0.486 0.501 0.452 0.507 0.502 0.459 HILEV Top quartile 0.385 0.420 0.414 0.422 0.503 0.496 Bottom quartile 0.522 0.534 0.533 0.535 0.549 0.549 CASH × NRET Top quartile − − 0.496 − − 0.512 Bottom quartile − − 0.582 − − 0.597 CASH × MTB Top quartile − − − 0.536 − 0.549 Bottom quartile − − − 0.531 − 0.545 CASH × HILEV Top quartile − − − − 0.526 0.526 Bottom quartile − − − − 0.563 0.562
a The dependent variable is an indicator variable taking the value of one for each repurchaser–nonrepurchaser matched pair. Explanatory variables are defined as the difference between each repurchaser–nonrepurchaser matched pair. Variable definitions prior to differencing are as follows: NRET is an indicator variable taking the value of one if the 12-month excess return is positive and zero otherwise, MTB is the unlevered market-to-book ratio market value of equity, CASH is the ratio of cash and cash equivalents to total assets, HILEV is an indicator variables taking the value of one if net leverage is above the sample median and zero otherwise, ∆EPS is earnings per share growth, LOSS is an indicator variable taking the value of one if reported earnings are negative and zero otherwise, PAYOUT is the dividend payout ratio, SIZE is the natural logarithm of total assets and DIST is an indicator variable taking the value of one if reserves are positive and zero otherwise. Further details of all variables (including Datastream item codes) are reported in table 2. All variables are measured at the fiscal year-end preceding the repurchase year (t-1). b Probability value for the likelihood ratio test. c For all continuous variables, implied probabilities for top and bottom quartiles represent the predicted probability that a firm repurchases its shares when the corresponding explanatory variable is set equal to the top and bottom quartiles of its respective distribution, respectively, and all other indicator (continuous) variables are set equal to zero (their sample means). For all indicator variables, implied probabilities for top and bottom quartiles represent the predicted probability that a firm repurchases its shares when the corresponding explanatory variable is set equal to one and zero, respectively, and all other indicator (continuous) variables are set equal to zero (their sample means)
41
Table 6 OLS regressions relating the value of shares reacquired in a given fiscal year to measures of underpricing, investment opportunities, cash holdings, gearing and a vector of control variables. The model is estimated using all available firm-year observations between January 1995 and December 2000 for firms undertaking at least one open market share repurchase during this period. The value of shares reacquired (COST) is equal to zero in firm-years where no shares are acquired, otherwise it is equal to the aggregate cost of shares bought during fiscal year t scaled by total assets at the beginning of year t. Probability values (two-tailed) are reported in parentheses.
Model:a
tjtjtjtjtjtj
tjtjtjtjtjtj
ACTPAYOUTDISTLOSSEPS HILEVCASHMTBNRETNRETCOST
,,101,91,81,71,6
1,51,41,31,2,10,)ln(
εδδδδδδδδδδδ
+++++∆++++++=
−−−−
−−−−
Full sample Trimmed sample Variable Model 1 Model 2 Model 3 Model 4 Model 5 Intercept -32.912 -36.059 -36.158 -34.799 -35.672
(0.001) (0.001) (0.001) (0.001) (0.001) NRETt 0.251 1.513 0.485 1.917 0.416
(0.744) (0.042) (0.629) (0.017) (0.712) NRETt-1 3.335 2.566 3.129 2.712 3.613
(0.001) (0.001) (0.002) (0.001) (0.001) MTB -0.371 -0.440 -0.275 -0.641 0.024
(0.038) (0.011) (0.444) (0.033) (0.960) CASH 11.685 13.189 11.978 12.467 14.321 (0.001) (0.001) (0.060) (0.003) (0.093) HILEV -0.864 -0.909 -0.982 -0.837 -1.628
(0.292) (0.253) (0.343) (0.328) (0.156) CASH × NRETt − − 9.207 − 13.996
(0.123) (0.058) CASH × NRETt-1 − − -5.152 − -8.360
(0.390) (0.258) CASH × MTB − − -0.620 − -3.559
(0.589) (0.067) CASH × HILEV − − 1.314 − 9.603
(0.871) (0.298) ∆EPS − -0.012 -0.012 -0.251 -0.197
(0.773) (0.778) (0.464) (0.564) LOSS − -3.218 -3.114 -4.045 -3.826
(0.020) (0.025) (0.037) (0.048)
DIST − 0.717 0.840 0.600 0.983 (0.658) (0.607) (0.768) (0.630)
PAYOUT − -0.107 -0.108 -2.149 -2.025 (0.456) (0.452) (0.043) (0.056)
ACT − 8.808 8.783 9.286 9.257 (0.001) (0.001) (0.001) (0.001)
Adj-R2 0.025 0.108 0.108 0.1131 0.1173 F 6.235 16.061 11.694 14.72 11.21 N 1243 1243 1243 1077 1077
42
43
Table 6 (continued) a The dependent variable is the natural logarithm of the cost of shares repurchased scaled by beginning-of-period total assets. To avoid generating missing values, we redefine COST as being equal to 0.00000001 in years where no shares are acquired. Explanatory variable definitions are as follows: NRET is an indicator variable taking the value of one if the 12-month excess return is positive and zero otherwise, MTB is the unlevered market-to-book ratio market value of equity, CASH is the ratio of cash and cash equivalents to total assets, HILEV is an indicator variables taking the value of one if net leverage is above the sample median and zero otherwise, ∆EPS is earnings per share growth, LOSS is an indicator variable taking the value of one if reported earnings are negative and zero otherwise, PAYOUT is the dividend payout ratio, SIZE is the natural logarithm of total assets, DIST is an indicator variable taking the value of one if reserves are positive and zero otherwise, and ACT is an indicator variable taking the value of one for fiscal year-ends after April 1999 and zero otherwise. Further details of all variables (including Datastream item codes) are reported in table 2. With the exception of NRETt, all variables are measured over the fiscal year preceding the repurchase year (t-1).
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