The Information Content of Share Repurchase Programs

Contrary to the implications of many payout theories, we find that announcements of open-market share repurchase programs are not followed by an increase in operating performance. However, we find that repurchasing firms experience a significant reduction in systematic risk and cost of capital relative to non-repurchasing firms. Further, consistent with the free cash-flow hypothesis, we find that the market reaction to share repurchase announcements is more positive among those firms that are more likely to overinvest. Finally, we find evidence to indicate that investors underreact to repurchase announcements because they initially underestimate the decline in cost of capital. IN RECENT YEARS OPEN-MARKET share repurchase programs have become an important payout method for many U.S. firms. According to data from COMPUSTAT, between 1984 and 2000 corporations spent approximately 26 percent of their total annual earnings on repurchases. Over 90 percent of these repurchases were open-market repurchase programs. Also, in 1999 and 2000, for the first time in history, industrial corporations spent more money on share repurchases than they did on dividends. Our objective in this paper is to better understand the economic motivations behind the decision to repurchase shares. Two major reasons for repurchasing shares are analyzed in the theoretical literature. The first is that management uses open-market share repurchases to signal better prospects (Bhattacharya (1979), Miller and Rock (1985), and Vermaelen (1984)).1 These papers suggest that repurchases can be used as a costly signal about future cash flows when markets are incomplete. As demonstrated by these papers, the repurchase decision can reveal information about ∗Grullon is from Rice University and Michaely is from Cornell University and IDC. We would like to thank David Ikenberry; George Kanatas; Rick Ruback; Cliff Stephens; Michael Weisbach; Bill Weld; and seminar participants at Cornell University, Dartmouth College, Harvard Business School, Rice University, the SEC, University of Michigan, University of Missouri-Columbia, University of North Carolina, University of Pennsylvania, the University of Utah, and the 1999 AFA Meetings for many useful comments and suggestions. Special thanks to Rick Green (the editor) and to an anonymous referee for many valuable comments and suggestions. The authors gratefully acknowledge the contributions of I/B/E/S International, Inc. for providing earnings per share forecast data, available through the Institutional Brokers Estimate System. Any errors are our own. 1 See also Ofer and Thakor (1987), Constantinides and Grundy (1989), Hausch and Seward (1993), and Persons (1997).