Stock repurchase and abnormal returns in den USA and Germany

Index

1. Introduction

2. Value Creation and Reduction of the Number of Shares

3. Economic Motivation for Stock Repurchase
3.1. Excess Capital Hypothesis
3.2. Undervaluation Hypothesis
3.3. Optimal Leverage Ratio Hypothesis
3.4. Management Incentive Hypothesis
3.5. Takeover Deterrence Hypothesis

4. Abnormal Returns around Stock Repurchase
4.1. Germany’s institutional setting
4.2. Abnormal Returns in the U.S. and Germany

5. Summary and Conclusion

References

Tables

1. Introduction

Two of the most prominent trends in corporate finance in the U.S. during the past 15 years are the growing popularity of share repurchases and the decreasing popularity of dividends. Repurchasing stocks is another way for managers to distribute money to shareholders, thus it plays an equivalent role as dividend payments.

Consistent with Grullon and Michaely (2002) U.S. corporations distribute cash by rather repurchasing stock than by paying dividends to shareholders. Fama and French (2001) argue in the same direction. Their study provides evidence that the proportion of corporations paying cash dividends fell from 66.5% in 1978 to 20.8% in 1999. According to Grullon’s (2000) findings the total of share repurchases exceeded the total of dividend payment for industrial firms in 1998.

In Germany share repurchases were highly restricted until 1998. As a consequence the volume of repurchases was small. The popularity of repurchases in the U.S. and in other countries was a strong argument for lifting the restrictions. These days, German companies announce buybacks regularly.

Although capital markets in the USA and Germany are efficient the impact of stock repurchase programs differ, resulting in higher stock performance after buyback announcements in Germany than in the USA.

The second chapter focuses on the impact of stock repurchases on earning per share. Chapter three follows Dittmar’s (2000) approach and discusses the prevalent motives of stock buybacks in a world of information asymmetries. Empirical results and the differences in the institutional setting in the U.S. and Germany will be discussed in chapter four. The paper closes with a summary and conclusive remarks.

2. Value Creation and Reduction of the Number of Shares

By repurchasing stock, the firm essentially decreases the number of shares outstanding. Managers may decide to repurchase stock in order to enhance the company's earnings per share (EPS). After the buyback, fewer shares remain; therefore EPS will rise because the profit will be distributed over a smaller total of shares. This results in higher earnings per remaining share. As a result, companies can calibrate EPS, one of the most significant financial indicators in the capital markets, by buying back stock. When corporate earnings per share are falling due to economic reasons, managers can try to fend off the effect on EPS by repurchasing stock (Fairchild, 2006).

However, there is no free lunch in corporate finance. At efficient capital markets, according to Modigliani and Miller’s (1958) Irrelevance Theorem all else equal companies can not create value by reorganizing the firm’s capital structure. Therefore repurchasing shares may lead to a mechanical increase in EPS but no to an increase in a firm's market value (Fairchild, 2006).

3. Economic Motivation for Stock Repurchase

In the presence of market imperfections and asymmetrically distributed information managers have different incentives to buyback stock. Dittmar (2000) and Chuang (2003) examine aspects for firms to buyback shares in their studies. Motives include five reasons and hypothesis why firm’s engage in stock repurchases: (1) undervaluation hypothesis; (2); excess capital hypothesis; (3) optimal leverage ratio hypothesis; (4) management incentive hypothesis and (5) takeover deterrence hypothesis. While the first four reasons are related to the shareholder’s interest the last one is related to outsiders.

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