The Share Repurchase Announcement Puzzle: Theory and Evidence H/T Abnormal Returns
Hong Kong University of Science & Technology – HKUST School of Business and Management
Southern Methodist University (SMU) – Edwin L. Cox School of Business – Department of Finance
Why is the mere announcement of an open-market share repurchase program, which involves no commitment to purchase shares, regarded as good news by the market? The first part of this paper provides a theoretical model to resolve this puzzle. The model predicts that firms with large underpricing can attract attention by announcing repurchases, and these firms do not have to use costly share repurchases as a value-correcting signal, because the trades from speculators lead to value corrections. Firms with small underpricing, however, cannot attract attention by announcing repurchases, and these firms have to use costly share repurchases as a value-correcting signal. The second part of the paper finds empirical evidence in favor of the predictions of the theoretical model.
Why is the mere announcement of an open-market share repurchase program, which involves no commitment to purchase shares, regarded as good news by the market? This paper explores this question, both theoretically and empirically.
In the first part of the paper, we develop a simple theoretical model that resolves this puzzle. In our model, speculators do not normally search for mispriced stocks because search is costly and mispricing is rare.
However, when mispricing does occur, in one type of equilibrium, which we call the “no share repurchase” equilibrium, firms that have large underpricing announce but do not repurchase. These firms do not have to use costly share repurchases as a value-correcting signal because their announcement will attract the attention of speculators, who will search and discover the underpricing, trade, and these buy trades will lead to price corrections. Overpriced firms in this equilibrium are indifferent to announcing because if they announce, they will be discovered by the trader who will then send a sell order. However, given noise in order flows, these sell trades transact at prices that are most likely to be low, but there is a possibility that prices may be high as well.1 In another type of equilibrium, which we call the “share repurchase” equilibrium, firms that have small underpricing announce and repurchase. These firms have to use costly share repurchases as a value-correcting signal because they cannot attract attention from speculators.
To summarize, our theoretical model predicts that a firm with large underpricing just announces a share repurchase but does not follow through, whereas a firm with small underpricing has to “put its money where its mouth is.”
In the second part of the paper, we take the above testable implication of our theoretical model to the data. We find that 24% of all firms that announce share repurchase programs in the period 1985-2012 do not purchase a single share in the fiscal year of the announcement. As a matter of fact, 13% of firms do not repurchase a single share within four fiscal years following the announcement year or prior to dropping out of Compustat. Thus, if a repurchase announcement signals value, and if our theoretical model is right, then these firms (with hypothesized large mispricings) simply use the announcement to attract scrutiny from speculators who discover their true value, whereas the rest of the firms (with hypothesized small mispricings) announce and repurchase shares to signal their true value.2 The differences between these two sets of firms should shed some light as to which type of firms use which type of signaling mechanism, enabling us to test the model’s predictions.
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