Share Buybacks

Table of Contents

Declaration

List of Figures

List of Tables

List of Abbreviations

1. Introduction

2. The State of Affairs in Buybacks
2.1. Reasons and Motivations
2.1.1. Long-term Shareholders
2.1.2. Managers
2.1.3. Short-term Shareholders
2.2. Requirements
2.2.1. German Law
2.2.2. Types of Share Buybacks
2.3. Effects
2.3.1. Market Price Effects
2.3.2. Earnings per Share Effects
2.3.3. Other Effects

3. Empirical Research
3.1. Sample Description and Empirical Method
3.2. Findings

4. Conclusion

References

Appendix

List of Figures

Figure 1. Cash distribution to equity holders (Grullon and Michaely, 2002, p. 1656)

Figure 2. Percentage of repurchasing firms by German indices (cf. Pick, 2008, p.12)

Figure 3. Distribution of firms by payout method (Grullon and Michaely, 2002,p.1661)

Figure 4. Hypothetical first payout choice of current non-payers (cf. Brav et al., 2005, Fig. 2 C on p.30)

Figure 5. Publicity duties in connection with buybacks in Germany (cf. Pertlwieser, 2006, p.46)

Figure 6. Average excess returns around the announcement of repurchases

Figure 7. Average excess returns in % 30 days before and after repurchase announcements

Figure 8. Repurchase reasons stated in the ad-hoc messages by the ob-served companies

List of Tables

Table 1. Tax differences between dividends and buybacks based on Pick (2008, p. 7)

Table 2. Examined DAX 30 listed companies and dates of buyback permission

Table 3. Final sample with planned buyback volumes

Table 4. Beta factors for the observed companies and periods

Table 5. Excess returns in % in the short-term period around buyback announcements

List of Abbreviations

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1. Introduction

Beginning with the subprime credit crunch in the USA in late 2007, which subsequently affected financial products all over the world, the global markets entered a period of severe economic downturn. The gravity of this downturn can be seen in the fact that the euro zone entered a recession, i.e., the shrinking of the gross domestic product in two consecutive periods, in late 2008.

In this context, recent finance literature (e.g., Rhodes and Stelter, 2009) advises companies to concentrate on cash management. The demand of the hour is to reduce or postpone outflows and guarantee inflows. That is, besides other measures, payouts to shareholders will be reduced. After years of two digit growth rates (Grullon and Michaely, 2002), share buybacks- much sooner than dividends¹ - will therefore see substantial cutbacks.

In Germany, payouts via buybacks have only gained significant importance since 1998². However, in the short time since then, a great deal of listed companies have been making use of the buyback method. Especially some of the larger firms listed in the DAX 30 such as DaimlerChrysler (7.5 bil. €), Deutsche Bank (5 bil. €), Münchener Rück (5 bil. €) and Siemens (10 bil. €) have recently announced sub- stantial buyback volumes (Haslauer, 2008). In this respect Sommer (2007) finds that in the approximately 10 years from the first of May 1998 to the end of 2007 the total amount of repurchased shares accounts for 50 bil. €.³

Using the pause for breath that can be expected during the time of the recession, this text gives an up-to-date overview of share buybacks as a means of payout.

In doing so, the focus lies on the question what motivates companies to pursue a buyback and which advantages in comparison to dividends exist. Furthermore I describe effects of share repurchases, on the announcement day as well as in later periods.

In critically evaluating the relevant literature, I describe the multiple motivations for performing buybacks in section 2.1. In order to do so I assign possible reasons to the three interest groups long-term shareholders, managers and short-term shareholders. I then state both legal and methodical requirements with a focus on the German market (2.2.) and show effects as stated in previous literature in part 2.3.

An empirical study in part three attempts to give a more recent understanding of market price changes as the result of buybacks performed by German blue chip companies listed in the DAX 30. By analysing the announcement effects of DAX 30 companies in repurchasing shares in 2006 and 2007, I show that there are substantial differences to the rest of the market.

Part four concludes.

2. The State of Affairs in Buybacks

The general concept of a buyback as a means of payout is rather simple. In a buyback the company reacquires its own shares and transfers them into the position “treasury stock” in the balance sheet. As a result, the shares in question cease to carry dividend rights. Another option is to eliminate the reacquired stock.

Despite the simplicity of the approach, buybacks only gained sub- stantial importance in the second half of the last century - especially in the USA. More and more companies chose to either substitute dividends for buybacks or at least use both methods of payout.

One of the most extensive empirical researches into dividends and buybacks was led by Grullon and Michaely (2002). The authors examined the use of dividends and buybacks as well as their possible substitution between 1972 and 2000. Analysing a sample of 15,843 US firms the authors find an increase in the number of repurchasing firms from 31% in 1972 to 80% in 2000. They also state that while in 1980 buyback payouts only covered 4.8% of total earnings, the buyback-earnings ratio in 2000 was 41.8% and thereby exceeded dividends (cf. Figure 1).

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Figure 1. Cash distribution to equity holders (Grullon and Michaely, 2002, p. 1656)

In Germany buybacks have not yet reached the same level as in the USA. That is dividends still exceed the payout via buybacks. However, a great proportion of German companies have repurchased stock between May 1, 1998 and December 31, 2006 as can be seen in Figure 2 (Pick, 2008).

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Figure 2. Percentage of repurchasing firms by German indices (cf. Pick, 2008, p.12)

This brings up some essential questions: What leads managers to decide for buybacks and what advantages exist in comparison to dividends? What has to be considered once the decision to go through with a buyback has been made? Does a buyback affect the market price of the outstanding shares and what are its other implications?

The following chapter seeks to answer those questions by explaining motivations for buybacks from three different perspectives in 2.1, stating legal and methodical requirements in 2.2 and showing the theoretical and practical effects in 2.3.

2.1. Reasons and Motivations

As early as 1961, Miller and Modigliani stated that, theoretically, dividend policy is irrelevant. In a perfect world⁴ the value creation of a company is only based on choosing the right - i.e., positive net pre- sent value (NPV) - projects. The pattern in which dividends are paid out would make no difference for neither the company nor the investors. The first can either reinvest the money right away or payout dividends and then issue new shares effectively making them independent of the payout decision. The latter can either generate an income stream by dividends or, in case dividends are not (yet) paid, generate homemade dividends by selling some of their shares. (Miller and Modigliani, 1961; Arnold, 2005, p.1010-1014)

Extrapolating from Miller and Modigliani’s ideas, one could - on a theoretical level - argue that payout via dividends and share buy- backs should be treated equally by investors. A demonstration by Mauboussin (2006), shown in Appendix A, points in the same direction.

Nevertheless, there are a multiple factors deviating from the model world: For example dividends and buybacks in many countries are taxed differently, transaction costs occur, the information provided by buybacks and dividends seem to be perceived in different ways.

These various real world incongruities are reflected in an interesting development described by Grullon and Michaely (2002). The authors find that the proportion of US companies using only dividends as a payout method has been declining since the early 1970s. During the same time the number of firms using buybacks or a mixture of buybacks and dividends increased substantially (cf. Figure 3).

DeAngelo et al. (2000; 2004) explain this development with the finding that, after 30 years of acquisitions, only the total number of dividend payers decreased. The number of high earning firms and the amount of dividends paid, on the other hand, increased.

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Figure 3. Distribution of firms by payout method (Grullon and Michaely, 2002,p.1661)

An analysis of Fama and French (2001) leads to similar conclusions: For a wide set of reasons share buybacks seem to gain importance while the number of dividend payers decreases. Based on the notion of changing firm characteristics as well as altering propensities to payout, the authors state the rising importance of stock option as a main reason for the growing number of share buybacks⁵. However, the focus of their explanation seems to mainly rest on a managers’ perspective.

The following is given in attempt to provide a more complete picture of possible motivations to pursue a buyback. I therefore attribute motives to the following three interest groups⁶:

1. Long-term shareholders
2. Managers
3. Short-term shareholders

2.1.1. Long-term Shareholders

It is assumed that the group of long-term shareholders will pursue wealth maximising goals that correspond with the long-term operational and financial health of the company. The interests of other stakeholders such as suppliers or customers might therefore partly correspond with this group.

Undervaluation

One argument often stated in the literature (e.g., Vermaelen, 1984; Ikenberry et al., 1995) is that buybacks can act as a signal of stock undervaluation. Undervaluation does not only lead to suboptimal returns for investors, but also imposes a possible takeover threat.

The company’s shares are trading under what the management - considering all available information - believes to be an objective value of the firm. By buying back some of the outstanding shares, the management leaks information into the market. Gerke et al. (2003) point to the fact that, by doing so, the information is not just announced but transferred into the market in the form of a costly signal that shows a certain level of commitment.

Hence such mispricings can be explained with an information asymmetry between the market and the company’s management. And indeed, as pointed out by D’Mello and Shroff (2000), the majority of analysts correct their estimates after share buybacks.

Empirical support for the undervaluation theory is given by Stephens and Weisbach (1998). The authors examine the stock performance of 450⁷ repurchase programs announced between 1981 and 1990 and find a positive correlation between buyback activity and under- valuation. Their findings are confirmed by Chan et al. (2005) who analyse a sample of 7725 firms buying back shares from 1980 until 1996⁸ finding negative abnormal returns⁹ of -12.58% in the year preceding the stock repurchase.

Other researches tried to quantify the importance of undervaluation as a reason to buy back shares. Controlling for book-to-market ratios, D’Mello and Shroff (2000) find that 74% of firms experienced undervaluation before the buyback (resulting in a high book value to market price ratio relative to market averages)¹⁰.

Interestingly undervaluation seems to be an even stronger motivation for small firms (Anderson and Dyl, 2004; D’Mello and Shroff, 2000). The reason for this is that public information about the business of small firms is less available than that for bigger firms, on which more analysts are focused (Gerke et al., 2003; D’Mello and Shroff, 2000; Chan et al., 2004).

However, it has to be said that not necessarily all companies stating that a buyback is pursued for undervaluation reasons are really undervalued. Chan et al. (2005) point to the possibility of false signalling in order to achieve windfall gains. This might also be the reason why Chan et al. (2004) find that often the initial price reaction is not sufficient. The markets seem to be hesitating and adapting the mispricings only slowly. This is also because otherwise the mere announcement of repurchases would always be enough to achieve short-term uplifts of the share price.

To put it in a nutshell, undervaluation seems to be an important reason to pursue a buyback for long-term shareholders. However, it is difficult to quantify what the market reaction should be¹¹, or how much of the initial market reaction has to be distributed to the undervaluation hypothesis and other factors respectively. Furthermore, and this seems to be the result of false signalling in the past, the market seems to delay the full price reaction.

Reduction of Cash and Agency Costs

Stephens and Weisbach (1998), analysing the sample described above, also find a positive correlation between above average cash flows and the announcements of buybacks. This indicates that firms use buybacks to flexibly reduce their cash reserves.

As a matter of fact there is also first-hand confirmation of this applica- tion of buybacks. Citing a poll taken by the Financial Executive Institute (FEI) in March 1999, Badrinath et al. (2001) state that 28% of 155 questioned FEI members use buybacks as a way to reduce excess cash.

One reason for the reduction of cash is to limit the sphere of managerial decisions (Gerke et al., 2003; Mauboussin, 2006). According to the agency theory shareholders have to make sure that the manager in place acts in line with their wealth maximisation demands. Investing in negative net present value projects, for example, would collide with this objective. Or put differently, cash lying around bears the danger of value destruction (Peters, 2006).

Hence a restriction of the manager’s available funds increases the probability that the money is only invested in the most promising ergo positive net present value projects. The excess cash is paid out, agency costs are reduced and shareholder value increased.

Nekat and Nippel (2005) confirm this view. The authors state that if the buyback is paid for with funds that would alternatively be invested in projects with a negative NPV, the value of the company rises. However, if funds are paid out that could be invested in projects with positive NPVs, value is destroyed.

Brav et al. (2005) interviewing 384 financial executives, argue that dividends are perceived to be as effective in reducing cash as buy- backs. However, Gerke et al. (2003) point to the fact that buybacks are more flexible than dividends. That is, dividend raises and cuts in a stable dividend policy are perceived to be a much stronger signal and create more volatility. This is confirmed by Stephens and Weisbach (1998), who state that there is nearly no penalty for not buying back the entire amount of shares announced or not repurchasing again in the future.

A slightly different distinction can be found in Jagannathan et al. (2000)¹². The authors find that buybacks are used especially for dealing with temporary cash flows, i.e., in good times (bear markets).

As opposed to this pro-cyclical approach, dividends are paid out of sustainable cash flows. The authors furthermore mention the tendency that cash flows from operations are paid out via dividends while buybacks are rather financed with non-operating cash flows. This goes hand in hand with the finding of Grullon and Michaely (2002), who state that if earnings are volatile, buybacks are more often used than dividends, which is consistent with the belief that dividends make the stock less risky and are therefore mainly used by mature firms¹³ (Brav et al., 2005).

Furthermore buybacks grant the possibility of regaining the decreased liquidity by reissuing shares bought back earlier. For this reason buybacks can also be described as a placeholder between acquisitions (Peters, 2006).

Serve Stock Option Programs

Reacquired shares can, as an alternative to taking them off the market, subsequently be used to serve stock option programs. According to Gerke et al. (2003), this method is a lot cheaper than initiating an equity increase and the resulting cost savings would effectively increase profits.

However, another, seemingly more important, point is that dilutions caused by the offering of employee stock options are reduced (Mauboussin, 2006). That is, because the company does not have to increase the proportion of equity to serve stock options, the firm is left with the same leverage (Chan et al., 2004). Assuming that the capital structure is at an optimal level, this keeps the weighted average cost of capital (WACC) low and will result in a higher number of beneficial projects.

As already mentioned above, Fama and French (2001) find that stock options become more and more important as a mean to reduce agency conflicts. In this respect reducing dilutions will also gain importance in the daily work of financial executives.

It is therefore not surprising that Badrinath et al. (2001) find that already 21% of financial executives state that reducing the costs and negative side effects of stock options programs is the main reason for them to decide for buybacks.

Change of Capital Structure

If, and this is the case for a lot of stock buybacks, the company destroys the shares after the buyback, the equity position is reduced. Assuming the amount of debts has not changed the debt-equity-ratio rises. Thus the company’s financial leverage increases.¹⁴ This might lead to lower WACC and a higher number of projects with a positive NPV.

Whether buybacks are performed to change the capital structure in practice was examined by Lie (2002). The author conducted one of the most in-depth researches dealing with self-tender offers¹⁵ and their possible use to optimise the capital structure. Analysing a sample of 286 buybacks between 1980 and 1997 Lie finds that firms facing a low debt ratio are more likely to buy back shares and achieve a debt-equity ratio on a proxy firm level, which might not be an optimal level but still acts as an adequate benchmark. His findings are supported by Chan et al. (2005) and Badrinath et al. (2001). The latter find that 12% of the polled financial executives state that capital structure changes are an important reason for a stock buyback.

Nevertheless there are potential downsides of the increased lever- age. On the one hand the danger of financial distress might arise if the credit rating of the company goes down. On the other hand, as Hackbarth (2008) points out for a debt financed buyback, possible cost savings and other positive effects have to offset additional cost of debt.

Takeover Defence

As a result of the leverage and liquidity effects of share buybacks, they are commonly described as an effective defence tactic when it comes to takeovers (Denis, 1990; D’Mello and Shroff, 2000; Gerke et al., 2003). This is because, as described above, the cash position is reduced while the debt ratio increases.

Denis (1990), observing 49 companies which faced a takeover threat in the years 1980 to 1987 and considered a repurchase, finds that 92% of the firms that actually implemented the buyback retained control. For the firms that did not go through with the buyback the success rate is at only 25%.¹⁶

Tax Advantage

A point on which prior research produced mixed results is tax advantages of buybacks as a reason to choose this method of payout. Bagwell and Shoven (1989 cited by Fama and French, 2001) argue that the increasing number of repurchases might indicate that dividends are substituted by repurchases in order to generate lower tax burdens for stockholders. Jagannathan et al. (2000), on the other hand, find it rather unlikely that tax advantages play a role in the buyback decision and explain the increasing number of repurchases with their inherent flexibility. Their notion is supported by DeAngelo et al. (2000; 2004), who find that tax changes do not lead to sharp increases or decreases of dividends, which rejects the substitution hypothesis.

One of the few actual empirical tests on this topic was led by Grullon and Michaely (2002). The authors find a significant positive correlation between buyback activity and tax advantages of share repurchases over dividends. These findings along with the fact that share buybacks allow investors to defer tax liabilities into later periods thus giving them the flexibility to decide the point of payout (Mauboussin, 2006), suggest that, at least from an investor perspective, buybacks are highly attractive.

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¹ For a more detailed argumentation why firms prefer to cut share buybacks before changing the dividend pattern the reader is referred to the discussion of the Financial Pecking-Order in section 2.1.2.

² However, Gerke et al. (2003) point to the fact that buybacks were allowed in Germany as early as 1884 and were prohibited in 1931.

³ The terms stock repurchase, share repurchase, stock buyback and share buyback are used interchangeably throughout the text.

⁴ Miller and Modigliani’s perfect world was based on the assumptions that there are no taxes, no transaction costs, identical interest rates for borrowing and lending money, free access to information and an indifference of investors between dividends and capital gains. (Arnold, 2005, p. 1011)

⁵ “[The] perceived benefits of dividends have declined through time. Some (but

surely not all) of the possibilities are: (i) lower transactions costs for selling stocks for consumption purposes, in part due to an increased tendency to hold stocks via open end mutual funds; (ii) larger holdings of stock options by managers who prefer capital gains to dividends; and (iii) better corporate governance technologies (e.g., more prevalent use of stock options) that lower the benefits of dividends in controlling agency problems between stockholders and managers. “ (Fama and French, 2001, p.40)

⁶ The attribution in some cases might not be as compelling as in others. However, as the most important motivations are captured, the grouping seems to fulfil its purpose.

⁷ The original sample consisted of all repurchase programs announced between 1981 and 1990. However, all announcements made in the fourth quarter of 1987, the time of the market crash, and distorted as well as incomplete datasets were excluded.

⁸ The author observes long term effects until 2000.

⁹ The terms excess return and abnormal return are used interchangeably throughout the text.

¹⁰ The analysis of D’Mello and Shroff only contains buybacks in the form of fixed priced tender offers. This might limit the applicability to buybacks in general.

¹¹ Mauboussin (2006) names five factors determining the signal strength: the type of buyback, the size of the buyback, the paid market premium, the commitment of insiders (mainly the amount of options held) and the reaction of insiders (e.g., selling their options)

¹² The authors cross-sectionally analyse the payout structure of firms that announced buybacks between 1985 and 1996

¹³ However, as already stated in the introduction, large companies often decide to use both dividends and repurchases.

¹⁴ For a more detailed explanation of capital structures, financial leverages and the effect on the value of the company the reader is referred to Miller and Modigliani (1963).

¹⁵ The self-tender offers as one method to buy back shares is described in section 2.2.2.

¹⁶ For a discussion of the price effects in connection with takeover threats the reader referred to section 2.3.