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American Accounting Association

Ben Haimowitz (212-233-6170)

Stock buybacks are a plus for shareholders, even when pay of executives is tied to firms' earnings per share, study finds

A 117% upsurge in stock buybacks last year by S&P500 companies has set off an upsurge in warnings about the nefarious ways executives use such repurchases to enrich themselves at the expense of shareholders. Yes, repurchases may provide a payout to investors, skeptics concede, but they can also be a way to mask business slowdowns and to artificially inflate earnings per share by the trick of simply reducing the number of shares outstanding. Particularly suspect in skeptics' eyes are repurchases engineered by executives whose pay is linked to meeting performance targets based on a company's earnings per share.

As one prominent commentator put it just last month, "Primarily stock buybacks are a shell game designed to boost CEO pay."

Yet, new research in the American Accounting Association journal The Accounting Review reveals that buybacks are by no means the evil those words suggest them to be, even in companies with EPS-contingent pay. True, stock repurchases find special favor in such companies, the study confirms. But even where such executive self-interest is at work, buybacks on the whole do not subvert the interest of shareholders and even have the net effect of modestly advancing them.

The study's authors, Steven Young of Lancaster University Management School and Jing Yang of Towers Perrin, find that "the predicted odds of a repurchase for firms for which executive compensation depends on EPS performance are almost twice the level observed for firms for which rewards are independent of EPS." Still, "on balance our evidence suggests that EPS-driven repurchases yield net benefits to shareholders... and we find no evidence that EPS-driven repurchase payouts occur at the expense of either investment myopia or dividend substitution."

In sum, "repurchase incentives created by EPS-contingent pay help align managers' interests with those of shareholders."

How can this be? How can initiatives undertaken by a executives in pursuit of their own self-interest end up benefiting shareholders as well? Prof. Young concedes that the findings came as something of a surprise.

"We undertook the research expecting to find executives lining their own pockets and shareholders losing out. But early on an economist colleague commented that, if the matter were that simple, companies would probably have abandoned EPS-contingent pay by now, and, since it was still very much a fact of corporate life, shareholders were probably realizing benefits from it. Our findings suggest my colleague had a point."

The professor adds: "In general, executive-pay schemes represent ways of addressing what scholars call the agency problem -- that is, how to motivate executives to act not just in their own self-interest but in the interest of the shareholders. Unfortunately, there's no perfect way to do this, and, while the amount of earnings per share is scarcely the best predictor of strong long-term company performance, it's an important number to the markets, so that, even if executives act opportunistically, the shareholders can still benefit.

"In short, among a bunch of imperfect pay options, motivating management to repurchase shares may be the least imperfect, problematic though buybacks sometimes can be.This doesn't mean that shareholders should let their guard down. Here as elsewhere they need to be vigilant, scrutinizing repurchases especially closely in any case where executive compensation is tied to per-share metrics."

The study's findings derive from a comparison of performance between firms that carried out stock repurchases once or more during the nine-year period 1998-2006 and a group of matched controls that were non-repurchasers. In all, the repurchasing firms accounted for 665 buybacks.

As indicated above, buybacks were twice as likely to occur in companies with EPS-contingent compensation as they were in controls. But no evidence emerged that the combination of buybacks with EPS-contingent pay resulted in inferior company results, whether on stock performance or returns on assets, in either the year or the two years following repurchases. In fact, that combination was associated with increased returns on assets in the post-buyback year in firms with below-average cash resources, a finding that casts doubt on the claim of buyback skeptics that repurchases divert funds from profitable investment opportunities. In addition, buybacks do not appear to substitute for or diminish payment of dividends. In the words of the study, "Findings suggest that dividends and repurchases represent complementary payout options that in conjunction yield higher payouts to shareholders regardless of whether repurchases are driven by EPS-contingent compensation arrangements."

Further, the study finds that EPS-contingent pay arrangements increase the likelihood of buybacks in situations where they are widely seen as useful -- in companies with surplus cash and in firms with undervalued stock.

In conclusion, the authors reiterate that "our findings reveal significant contracting benefits from the repurchase incentives that result from linking executive compensation to EPS" -- benefits that suggest "why EPS-based targets remain a popular choice in executive compensation contracts despite their obvious limitations."

Entitled "Stock Repurchases and Executive Compensation Contract Design: The Role of Earnings per Share Performance Conditions," the study is in the March issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.


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