Stock Repurchases and the EPS Enhancement Fallacy

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1 Financial Analysts Journal Volume 64 Number 4 28, CFA Institute Stock Repurchases and the EPS Enhancement Fallacy Jacob Oded and Allen Michel A common belief among practitioners and academics is that the increased EPS associated with a stock repurchase creates value for a firm s shareholders. This belief is flawed. With the use of a numerical example and an analysis of ExxonMobil s recent stock repurchases, this article demonstrates the magnitude of the distortion that arises from using EPS to make such repurchase decisions. The effect of share repurchase is also compared with the effects of alternatives payment of dividends and cash accumulation. Relative to cash accumulation, neither the negative effect of dividends nor the positive effect of repurchases on EPS is associated with changes in the wealth of shareholders at time zero. Exxon spent 6%, or $29 billion, of its cash flow on repurchases in 26, more than any other firm in the Standard & Poor's 5-stock index and a tenfold increase since 2. The firm has retired 16% of shares in the past five years, adding an estimated 88 cents to earnings of $6.68 per share. Pumping Cash, Not Oil, BusinessWeek, 28 May 27 In the past several years, record numbers of firms have carried out share repurchases. Firms as diverse as 3M, Capital One Financial Corporation, Caterpillar, CBS Corporation, and Accenture have announced repurchases of more than $1 billion each. Firms now distribute as much cash back to shareholders with repurchases as they do with dividends (see Grullon and Michaely 22). A reason that is commonly cited in firm press releases and executive surveys for the increased use of share repurchases is to increase EPS (see, for example, Grullon and Ikenberry 23). This article addresses the effect of stock buybacks on both a firm s earnings per share and the value of an investor s holdings. Firms generally choose among several alternatives for using their excess cash. These typically include dividend payment, share repurchase, and cash accumulation (no payout). We consider each of these alternatives. Miller and Modigliani (1961) demonstrated that in a perfect world, payout policy does not matter. The literature that followed their seminal Jacob Oded is assistant professor of finance and economics at the School of Management, Boston University, and a lecturer at Racanati Graduate School of Business Administration, Tel Aviv University, Israel. Allen Michel is professor of finance and economics at the School of Management, Boston University, and a senior expert at the Michel-Shaked Group, Boston. work focused, however, on explaining how market imperfections make payout policy relevant. For a firm s payout by way of stock repurchases, a broad range of reasons has been given. They include signaling of undervalued equity in conditions of information asymmetry, reducing the agency costs of having free cash, substituting repurchases for dividends to lower taxes, and capital structure adjustments. 1 We abstract from these motivations and focus on EPS growth. Arnott and Asness (23) and, more recently, Zhou and Ruland (26) demonstrated empirically that, despite the negative effect of dividends on earnings growth, high dividend payouts are not associated with weak future earnings growth. In fact, high dividends actually predict earnings growth. Because repurchases are increasingly used to substitute for dividends as a payout tool, understanding the effect of repurchases on EPS growth is important. Our analysis is closely related to these investigations and suggests that the positive effect that repurchases have on earnings growth should not be confused with real economic growth at the firm. As an application of our arguments, we consider the effect that alternative payout policies would have had on the EPS of ExxonMobil, which has a recent history of sizable share repurchases and large dividend payments. We then compare those results with ExxonMobil s actual payout policy , CFA Institute

2 Stock Repurchases and the EPS Enhancement Fallacy EPS in Various Payout Policies To understand the effects of alternative payout policies available to a firm, we consider the following financial options: (1) accumulating all funds earned each year without paying out any cash, (2) paying dividends with all of the firm s earnings, and (3) using all of the firm s earnings to repurchase shares. Without loss of generality, we demonstrate our insights with the use of a numerical example. Consider an all-equity firm that initially has 1 million shares outstanding. The firm s balance sheet consists of $5 million in risky assets and $5 million in cash. The firm s shares are trading at $1 per share. The risky assets are expected to generate a 15 percent return (in cash earnings) each year. The firm s cash is expected to generate a 5 percent return each year. The expected return on the firm s total assets is thus 1 percent. During 1, the firm earns $75, from its risky assets and $25, from its cash assets. Thus, at the end of 1, the firm has earnings of $1 million and its EPS is $1. To simplify the analysis, and to focus on the effects of payout policy, we assume that the firm does not have new risky investment opportunities for its cash. Thus, the firm can either pay out free cash flow to its shareholders or invest the free cash at the risk-free rate. We also assume that cash payouts can be distributed only from the firm s earnings. In addition, we assume no taxes, no signaling motivation, and no agency problems. Policy of Cash Accumulation. If the firm has a policy of cash accumulation, the firm reinvests all earnings in safe assets. Thus, at the end of 1, the firm is valued at $11 million, consisting of the $6 million of cash assets and $5 million of risky assets. On a per share basis, given 1 million shares outstanding, at the end of 1, the value per share amounts to $11. At the end of 2, the firm expects to have accumulated ($6 1.5) + ($5 1.15) = $12.5 million. On a per share basis, given 1 million shares outstanding, the result is $12.5 per share. This increase in funds accumulated by the firm causes the expected EPS in 2 also to increase, resulting in an expected EPS of ($6.5) + ($5.15) = $1.5 per share. Table 1 illustrates the expected evolution of the firm s asset composition (risky and safe), the firm s value, stock price, and EPS through 1 for the cash accumulation strategy. Figure 1 depicts the results in Table 1 graphically. Panel A shows the expected change in firm value over time and the expected composition of risky and safe assets. It demonstrates that because the firm accumulates rather than distributes the cash that it earns, its value increases. The firm also becomes safer because the proportion of safe assets increases over time. Panel B demonstrates the evolution of the stock price and EPS. The data show that because the number of shares is fixed and the firm accumulates cash, both the share price and EPS increase over time. Policy of Stock Repurchase. In our example of stock repurchase, the firm uses all of its earnings at the end of each year to buy back shares. We now consider the implications of this policy for firm value, stock price, and EPS. At the end of 1, the firm is expected to have accumulated $1 million in earnings and to have the $1 million available to repurchase shares. Just prior to the share repurchase, the expected value of the firm is $11 million. At the end of 1, because there are 1 million shares outstanding, the shares are now traded at $11 per share (as in the case of cash accumulation). At this price, the firm is expected to use its earnings to repurchase 9,99 shares, leaving 99,91 shares outstanding. Table 1. Evolution of Cash Accumulation Policy Item Risky assets Safe assets Risky assets/safe assets Firm value No. shares outstanding Earnings EPS Stock price Note: All data are in $ millions except EPS ($), stock price ($), and number of shares (millions). July/August

3 Financial Analysts Journal Figure 1. Evolution in Firm Value, Share Price, and EPS over Time with Cash Accumulation Millions of Dollars 25 A. Firm Value Dollars Safe Assets in Firm Risky Assets in Firm B. Share Price and EPS Share Price EPS Because of accounting rules (Statement of Financial Accounting Standards No. 128, Earnings per Share), shares purchased at the end of the year do not reduce the number of shares outstanding to be used in the firm s reported EPS calculation for that year. That is, the time weighting of the number of shares used in the EPS calculation causes the shares repurchased at the end of 1 to receive no weight in the 1 calculation. As a result, rather than 99,91 shares, 1 million shares are used in the calculation. Thus, for EPS reporting purposes, the number of shares outstanding is still 1 million, , CFA Institute

4 Stock Repurchases and the EPS Enhancement Fallacy and at the end of 1, the firm s reported EPS is expected to be $1 million/1 million shares, or $1. per share, even though at the end of 1, in fact, only 99,91 shares are outstanding. The firm starts 2 with $5 million of safe cash assets and $5 million of risky assets because it expects to have repurchased $1 million worth of shares by the end of 1. By the end of 2, the firm expects to again earn $1 million. The share price at the end of 2, prior to the repurchase, will then be $11 million/99,91 shares, or $12.1. Using its $1 million of earnings in 2, the firm can repurchase 82,645 shares, leaving 826,446 shares outstanding. Again in 2, however, the firm will not include in its EPS calculation the shares that it repurchased at the end of 2. So, because of accounting rules, at the end of 2, although the firm will report 826,446 shares outstanding, for purposes of calculating EPS, the firm uses 99,91 shares. Thus, in the EPS calculation, the firm again reports earnings of $1 million using 99,91 shares outstanding, resulting in EPS of $1.1. Table 2 illustrates the expected evolution through 1, given the firm s repurchase strategy, of the firm s asset composition, value, value of cash distributed through shares repurchased, and so on, as in Table 1. Figure 2 depicts the results described in Table 2. Panel A of Figure 2 indicates that neither the value of the firm nor the proportion of risky assets to safe assets increases over time. The reason is that all earnings are distributed instead of the cash being accumulated as in the scenario described in Table 1 and Figure 1, where earnings increased over time. The total value to investors (firm value plus value of cash paid out), however, is the same as in the case of cash accumulation. Indeed, as a comparison of Panel B in Figure 2 with Panel A in Figure 1 demonstrates, the path of the total value to investors over time under the policy of repurchase is identical to that of the total value to investors in the case of cash accumulation. Thus, from the shareholder s perspective, the repurchase does not add any economic value. Instead of having cash in the firm, however, the cash is now in the investor s hands. Comparison of Panel C of Figure 2 with Panel B of Figure 1 demonstrates that the stock price and EPS increase more with share repurchase than in the case of cash accumulation. The increase has no effect, however, on expected shareholder wealth. The firm uses safe cash to retire risky shares. On the one hand, the total number of shares decreases, which increases EPS relative to the cash accumulation case. In contrast, because the firm uses cash to repurchase the shares, it is not generating earnings on that cash; thus, it is reducing EPS relative to cash accumulation. Overall, expected EPS is higher in the repurchase scenario than in the cash accumulation scenario because the expected return on the firm s assets increases with share repurchase. The reason is that the retirement of cash causes the relative weight of the safe asset (cash) in the firm s asset composition to decrease whereas the relative weight of the risky assets increases. No value is added, however, for the existing shareholders. Instead of having safe cash in the firm, the shareholders now have safe cash in their pockets and riskier shares. Table 2. Evolution of Share Repurchase Policy Item Risky assets Safe assets (in firm) Risky assets/safe assets Firm value Accumulated value of cash distributed through share repurchase a Total value to shareholders Earnings No. shares outstanding EPS Stock price Note: All data are in $ millions except EPS ($), stock price ($), and number of shares (millions). a Under the assumption that distributed cash is invested (by the selling shareholders) in government bonds and earns the risk-free rate. July/August

5 Financial Analysts Journal Over time, the difference between the policies of cash accumulation and repurchase becomes significant when the firm s asset composition (ratio of risky to safe assets) is being compared. For example, Panel A in Figure 1 shows that by 1, under a policy of cash accumulation, risky assets account for only about 28 percent of the value of safe assets. As a result, return on total assets (risky and safe) will have decreased significantly. Panel A in Figure 2 shows that, in contrast, by 1 under a repurchase policy, the value of risky assets will still equal the value of the safe assets, causing the expected return on assets to be greater in the repurchase case than in the cash accumulation case. Thus, although EPS is expected to be greater in the repurchase case, the effect is merely a risk return trade-off. The Policy of Dividends. Under the policy of paying dividends, the firm pays out all its earnings at the end of each year as dividends. What are the implications of this policy for value, stock price, and EPS? Figure 2. Evolution in Firm Value, Total Value to Shareholders, Share Price, and EPS over Time with Repurchase A. Firm Value Millions of Dollars Safe Assets in Firm Risky Assets in Firm Millions of Dollars 25 B. Total Value to Shareholders Total Safe Assets Risky Assets in Firm (continued) , CFA Institute

6 Stock Repurchases and the EPS Enhancement Fallacy Figure 2. Dollars 3 Evolution in Firm Value, Total Value to Shareholders, Share Price, and EPS over Time with Repurchase (continued) C. Share Price and EPS Share Price EPS At the end of 1, the value of the firm prior to paying out dividends is $11 million ($5 million + $5 million + $1 million). The firm is expected to use its entire earnings to pay dividends of $1 million at the end of the year. As a result, the value of the firm at that time will drop to $1 million. On a per share basis, given 1 million shares outstanding, EPS at the end of 1 is $1 per share. The share price just prior to the dividends being paid is $11 per share. Immediately following the dividend payments, the share value falls to $1 per share because of the $1 million payout. During the second year, the firm is also expected to earn $1 million. At the end of the second year, it again uses the $1 million to pay dividends. Prior to the dividend payments, the share value is $11 million/1 million shares, or $11 per share. Following the dividend payout, the share value again falls to $1 million, or $1 per share. The EPS at the end of the second year is $1 million/1 million shares, or $1 per share. Table 3 illustrates the expected path describing the firm s asset composition and value, the value of Table 3. Evolution of Dividend Policy Item Risky assets Safe assets (in firm) Firm value Accumulated value of dividends paid a Total value to shareholders EPS Stock price Risky assets/safe assets Note: All data are in $ millions except EPS ($) and stock price ($). a Under the assumption that distributed cash is invested (by the receiving shareholders) in government bonds and earns the risk-free rate. July/August

7 Financial Analysts Journal the dividends paid, the stock price, and the EPS through 1 under the policy of paying cash dividends. Figure 3 demonstrates graphically the key results of Table 3. Panel A of Figure 3 shows that with a policy of paying dividends, a firm s value and asset composition do not change over time. This result is identical to that of the policy of repurchase (see Panel A of Figure 2), but it differs from a policy of cash accumulation (see Panel A of Figure 1). In our example, the policy of paying dividends is similar to stock repurchase because in both cases, the firm pays out all the cash that it generates. The A panels of Figures 2 and 3 show that the ratio of risky assets to safe assets is also identical in the policies of dividends and repurchase, but the ratio in these cases differs from the ratio in the case of cash accumulation shown in Figure 1. Figure 3. Evolution in Firm Value, Total Value to Shareholders, Share Price, and EPS over Time with Dividend Payment Millions of Dollars 1 A. Firm Value Safe Assets in Firm Risky Assets in Firm Millions of Dollars 3 B. Total Value to Shareholders Total Safe Assets Risky Assets in Firm (continued) , CFA Institute

8 Stock Repurchases and the EPS Enhancement Fallacy Figure 3. Dollars 1 Evolution in Firm Value, Total Value to Shareholders, Share Price, and EPS over Time with Dividend Payment (continued) C. Share Price and EPS Share Price EPS The total value (to shareholders), however, is identical under all three policies. Indeed, the evolution of the total value (the value of the firm plus the value of cash paid out) in Panel B of Figure 3 is identical to the evolution of total value in Panel A of Figure 1 and Panel B of Figure 2. Thus, from the shareholders perspective, as in the cases of cash accumulation and repurchase, a policy of dividend payment does not add any economic value. Panel C of Figure 3 demonstrates the time path of the stock price and EPS based on a policy of paying dividends. Unlike the situation for the policies of cash accumulation (see Panel B of Figure 1) or repurchase (see Panel C of Figure 2), neither the stock price nor EPS is enhanced by dividend payout. From the shareholders perspective, however, this result is not a disadvantage because the total value of an investor s holdings (shares and cash) is the same under each of the three policies. In Figure 4, we focus on the results for the stock price and EPS over time. Panel A compares the stock price under the three policies. Relative to a benchmark policy of no payout (i.e., cash accumulation), a repurchase policy enhances the stock price whereas a dividend policy results in a flat stock price. As Panel A demonstrates, these price differences become more significant with time. By 5, relative to the price associated with the cash accumulation benchmark, repurchase enhances the stock price by about 4 percent whereas dividends lower the stock price by 36 percent. By 1, repurchase enhances the stock price by about 15 percent whereas dividends result in the stock price being 54 percent lower. But keep in mind that this difference has no effect on overall shareholder wealth. Indeed, at time zero, the stock price is the same regardless of the firm s assumed payout policy. Moreover, although the total value of a shareholder s holdings increases over time, this value is invariant with respect to payout policy. In other words, at a given point in time, the payout policies result in identical total values for the shareholder. Panel B of Figure 4 compares EPS over time under the alternative payout policies. Relative to the benchmark policy of cash accumulation, a repurchase policy enhances EPS whereas a dividend policy results in EPS remaining unchanged. Furthermore, a comparison of Panel A with Panel B shows that the impact of a repurchase policy on EPS is much more dramatic than its impact on the stock price. In 1, EPS is $1. per share regardless of the payout policy. Starting from 2, however, EPS varies by payout policy. Under a policy of cash accumulation, 2 s EPS is $1.5 per share; under a policy of stock repurchase, it is $1.1 per share; and under a policy of the payment of dividends, it is $1. per share. By 5, relative to a policy of cash accumulation, EPS has grown under a policy of repurchase by more than 2 percent whereas under a dividend policy, EPS is approximately 2 percent lower. By 1, in relation to the same benchmark policy, EPS has grown under a policy of repurchase by about 52 percent whereas EPS is approximately 36 percent lower under a dividend policy. July/August

9 Financial Analysts Journal Figure 4. Comparison of Stock Price and EPS under Three Payout Policies Stock Price ($) 3 A. Stock Price EPS ($) B. EPS Cash Accumulation Repurchase Policy Dividend Policy , CFA Institute

10 Stock Repurchases and the EPS Enhancement Fallacy For the firm that is maximizing EPS, the stock repurchase plan described here yields the largest EPS. Again, however, this effect is not associated with a change in overall shareholder wealth; the shareholder is equally well off under all policies. 2 Reconciling the Perfect Markets Framework and the Real World Practitioners tend to associate changes in EPS with changes in value. In particular, they tend to interpret the increase in EPS resulting from a repurchase program as being value enhancing. Our analysis suggests, however, that even though payout policy has a dramatic effect on EPS, it has no effect on shareholder value. Stated differently, the decision to use excess cash has no effect on the overall wealth of the shareholder existing at time zero. But although this result holds in perfect markets, in actual situations, other factors such as taxes, agency costs, information asymmetry, and transaction costs make the choice among dividend, repurchase, and cash accumulation relevant for value enhancement. In particular, firms do not randomly pick a payout policy. When determining a payout policy, firms consider their prospects. For example, in actual situations, firms that engage in share repurchases probably believe one or both of the following: (1) Their shares are undervalued; (2) given the projects available for them to invest in, the remaining mix of risky and safe assets after a share repurchase will be optimal for them. To the extent that the managers are correct in either of these beliefs, the shareholders that hold their equity stake from time zero may have a greater probability of maximizing overall wealth in reality than they do in theory. Achieving the higher EPS in the repurchase scenario, however, depends partly on the firm s ability to continue to generate at least as much profitability in the future from its changing mix of assets (including riskier assets that can introduce volatility) as in the past. That is, given that an optimal mix of assets and cash exists in real-life situations and given that information is asymmetrical, a repurchase is good news. It reveals to the public that the firm is persistently generating free cash, which the firm removes from its composition of assets through stock repurchases so that the firm will revert back to its optimal mix. Similarly, when markets are not perfect, the cost of capital generally differs from the return on investment. A firm that holds more cash than needed for its operations namely, a firm that does not disburse its free cash is usually destroying value for its shareholders because the return on the cash that it generates is lower than its cost of capital (the required cost of equity and debt). In fact, this is often the reason that shareholder activists urge firms with cash hoards to initiate share repurchase programs. Application: Payout Policy at ExxonMobil In this section, we present an application of our argument to ExxonMobil. Because our goal is to focus on the effects of payout policy on EPS that are not associated with the enhancement of shareholder wealth, we abstract from such frictions as undervaluation, optimization of asset mix, and capital structure. In particular, we consider the background of the epigraph with which we opened this article. We determine the EPS associated with alternative payout policies that were available to ExxonMobil in 22 through 26. Although the differences in EPS between alternative payout policies are largely devoid of economic content, we also present the tax savings associated with each policy. ExxonMobil has executed a sizable stock repurchase program in the past several years. In 26 alone, the firm spent more than $29 billion repurchasing shares. In addition, ExxonMobil has had a policy of making significant dividend payouts. Table 4 presents relevant financial information for ExxonMobil for the years (Note that we use the U.S. T-bill rate shown in Table 4 in the following analysis as the risk-free rate at which the firm can invest cash balances. Other rates could be used without significantly affecting the results.) In this analysis, we consider what the EPS for ExxonMobil would have been under alternative payout policies. We start with the financial results of 21 as a base year. First, we consider what EPS would have been if ExxonMobil had no repurchase program in the years but kept its dividend at its actual level. Next, we consider what EPS would have been if ExxonMobil had kept its repurchase program during but paid no dividends. Finally, we consider what EPS would have been had ExxonMobil not paid out any cash during (a cash accumulation policy). Table 5 indicates how the different EPS values over time were calculated. ExxonMobil s EPS If No Repurchase. Panel A of Table 5 indicates that without repurchases during 22 26, ExxonMobil would have had billion shares on its balance sheet at the end of 26 instead of the current billion and the weighted billion shares that it used in its EPS calculation. And it would have had an additional $69.3 billion of cash. Its EPS with no repurchase would have been $5.85 instead of the actual $6.68. July/August

11 Financial Analysts Journal Table 4. ExxonMobil: Actual Financial Data, 22 6 Item Shares outstanding, beginning of year 6,89 6,7 6,568 6,41 6,133 Amount spent on repurchase 4,8 5,9 1, 18,2 29,6 Shares repurchased Shares outstanding, end of year 6,7 6,568 6,41 6,133 5,729 Shares for compensation plans End-of-year earnings 11,11 2,96 25,33 36,13 39,5 Weighted average no. shares 6,78 6,634 6,482 6,27 5,913 EPS Total dividends paid 6,2 6,5 6,9 7,2 7,6 Dividends per share Average three-month T-bill rate Notes: All data are in $ millions except per share data ($), number of shares (millions), and T-bill rate (percent). ExxonMobil restated its earnings for 22 and 23. This table uses the restated numbers rather than the original numbers; the difference is not significant. The greater EPS associated with repurchase occurred for several reasons. First, because of the repurchase, ExxonMobil had fewer shares outstanding, but also, because it had less cash to invest, it had reduced earnings. The overall effect is an increase in EPS, but this increase is primarily a risk return trade-off because ExxonMobil has less safe cash that earns a low return. Its risky assets account for a higher portion of the value, and as a result, its EPS is higher. In addition, part of the increase in EPS associated with the repurchase occurred because without the repurchase, Exxon- Mobil s tax bill would have been $983 million higher, about $.17 per share. 3 ExxonMobil s EPS If No Dividend. If Exxon- Mobil had kept its repurchase program but not paid any dividends during 22 26, the number of shares outstanding would not have been affected (i.e., ExxonMobil would still have had billion shares at the end of 26 and would have used billion shares for its EPS calculation; see Table 4) but it would have had an additional cash balance of $35 billion by the end of 26 (see Panel B of Table 5). As a result of the earnings on its cash balance, ExxonMobil s EPS would have been $6.82 instead of the actual $6.68. The dividend paid by ExxonMobil reduced its EPS, but it is important for the reader to understand the sources of the reduction. ExxonMobil had less in earnings because it had a smaller cash balance than without the dividend. But this cash obviously had value to the investors. Instead of having it in the firm, the investors had it in their pockets. In addition, the dividend reduced ExxonMobil s earnings on its cash and, as a result, reduced its tax liability. Without the dividend, ExxonMobil s tax bill would have been $562 million higher about $.1 per share. ExxonMobil s EPS If No Payout. Panel C of Table 5 indicates that without any payout for dividends or repurchase during 22 26, ExxonMobil would have had almost 7 billion shares on its balance sheet at the end of 26 (instead of billion or the weighted billion shares that it used in its EPS calculation). It would have had an additional $14.3 billion of cash, and its EPS would have been $5.97 instead of the actual $6.68. Without any payout, EPS is lower than the actual figure because EPS would not have been increased by share repurchases. It is higher than in the scenario that excluded only repurchases (Panel A), however, because in the Panel C scenario, dividends are also excluded. In this scenario, ExxonMobil has more cash than in any other scenario; therefore, its asset composition is the safest of the three. As a result, its EPS is greater than the EPS under a policy of dividend payout only (the no repurchase scenario of Panel A). In addition, ExxonMobil s tax bill would have been higher than its actual tax bill by $1.546 billion about $.26 per share. Of the per share increase, approximately $.17 results from no repurchase and approximately $.1 results from paying no dividend. 4 Table 6 presents a summary of the results for EPS. A repurchase policy increases EPS, whereas a policy of dividend payments reduces EPS. In the scenario of no payout, which corresponds to cash accumulation, the EPS path is lower than the actual path but higher than the path without repurchase. In particular, as Table 6 demonstrates, , CFA Institute

12 Table 5. Stock Repurchases and the EPS Enhancement Fallacy ExxonMobil: Calculation of Hypothetical EPS Paths under Alternative Payout Policies, 22 6 Item A: Scenario without repurchase a Additional cash, end of year 4,8 1,716 2,764 39,11 69,274 Additional earnings from cash during year ,458 Tax on additional earnings Additional earnings net of taxes ,475 No. shares outstanding if no repurchase 6,827 6,858 6,99 6,952 6,999 EPS if no repurchase Tax savings per share from repurchase B: Scenario without dividends b Additional cash, end of year 6,2 12,721 19,679 27,3 35,69 Additional earnings from cash during year ,46 Tax on additional earnings Additional earnings net of taxes No. shares outstanding (unchanged) 6,78 6,634 6,482 6,27 5,913 EPS if no dividends Tax savings per share from dividends C: Scenario without payout c Additional cash, end of year 11, 23,437 4,442 66,14 14,344 Additional earnings from cash during year ,674 3,864 Tax on additional earnings ,546 Additional earnings net of taxes ,4 2,319 No. shares outstanding if no payout 6,827 6,858 6,99 6,952 6,999 EPS if no payout Tax savings per share from payout Notes: All data are in $ millions except for per share data ($) and shares outstanding (millions). In calculating EPS under the different payout policies, the following assumptions were made: (1) Shares were assumed to have been repurchased evenly throughout the year. (2) Additional cash that the firm accrued was invested at the three-month risk-free rate. (3) ExxonMobil would have paid taxes on additional cash at its marginal tax rate of 4 percent. (4) Earnings considered are nondiluted earnings. a For this scenario (dollars in millions): Additional cash, end of year : For 22, this figure is the amount spent on repurchase in the current year (Table 4) namely, $4,8. For 23 and forward, it is the amount spent on repurchase in the current year (Table 4) plus additional earnings net of taxes in the previous year (from this panel) plus additional cash, end of year in the previous year (from this panel). For example, for 23, the calculation is $5,9 + $16 + $4,8 = $1,716. Additional earnings from cash during year are approximated by assuming one-half of end-of-year cash is invested at the T-bill rate for the whole year. For example, for 22, this figure is ($4,8/2) 1.12% = $27. No. shares outstanding if no repurchase : In 22, this figure is beginning-of-year shares outstanding (Table 4) plus shares for compensation plans (Table 4) that is, 6, = 6,827. For 23 and forward, it is number of shares if no repurchase from the previous year (from this panel) plus shares for compensation plans for the current year (Table 4). For example, for 23, it is 6, = 6,858. EPS if no repurchase is end-of-year earnings (Table 4) plus additional earnings net of taxes (from this panel) divided by number of shares outstanding if no repurchase (from this panel). For example, for 22, it is ($11,11 + $16)/6,827 = $1.62. Tax savings per share from repurchase is tax on additional earnings (from this panel) divided by the weighted average number of shares (Table 4). For example, for 22, the figure is $11/6,78 $.. b For this scenario: Additional cash, end of year : For 22, this figure is total dividends paid in the current year (Table 4), namely, $6,2. For 23 and forward, it is total dividends paid in the current year (Table 4) plus additional earnings net of taxes from the previous year (from this panel) plus additional end-of-year cash from the previous year (from this panel). For example, for 23, the calculation is $6,5 + $21 + $6,2 = $12,721. Additional earnings from cash during year are approximated by assuming half of end-of-year cash is invested at the T-bill rate for the whole year. For example, for 22, this figure is ($6,2/2) 1.12% = $35. No. shares outstanding (unchanged) is as in Table 4. EPS if no dividends is end-of-year earnings (Table 4) plus additional earnings net of taxes (from this panel) divided by number of shares outstanding if no dividend (from this panel). For example, for 22, this figure is ($11,11 + $21)/6,78 = $1.63. Tax savings per share from dividends is tax on additional earnings (Panel A) divided by the weighted average number of shares (Table 4). For example, for 22, the amount is $11/6,78 $.. c In this scenario: Additional cash, end of year : This figure is additional cash resulting from the amount spent on repurchase (Panel A) plus end-of-year additional cash resulting from the amount spent on dividends (Panel B). For example, for 22, the calculation is $4,8 + $6,2 = $11,. Additional earnings from cash during year are approximated by assuming half of end-of-year cash is invested at the T-bill rate for the whole year. For example, for 22, this amount is ($11,/2) 1.12% = $62. No. shares outstanding if no payout is the same as in Panel A. EPS if no payout is end-of-year earnings (Table 4) plus additional earnings net of taxes (from this panel) divided by number of shares outstanding if no payout (from this panel). For example, for 22, this amount is ($11,11 + $37)/6,827 = $1.62. Tax savings per share from payout is tax on additional earnings (from this panel) divided by the weighted average number of shares (Table 4). For example, for 22, it is $25/6,78 $.. July/August

13 Financial Analysts Journal Table 6. ExxonMobil s EPS in Different Payout Policy Scenarios, 22 6 EPS Circumstances Actual EPS $1.62 $3.16 $3.91 $5.76 $6.68 EPS if no repurchase (with dividends) EPS if no dividends (with repurchase) EPS if no payout (cash accumulation) had ExxonMobil not repurchased any shares in 22 26, its EPS would have been $6.68 $5.85 = $.83 lower. Using 22 as a base year, EPS growth would have been = 16.% lower than it was. Thus, we estimate that about 16 percent of ExxonMobil s EPS growth in these years can be attributed primarily to financial policy rather than to performance improvement. 5 Conclusion The exclusive use of EPS to evaluate firm performance can be misleading. We have considered one aspect of problems arising from the simplistic use of EPS namely, the effect of payout policy on EPS. Because of the increasing role of share repurchases as a payout tool, we focused on repurchases. We showed that the value of an investor s holdings is invariant with respect to the choice of payout policy. Yet, each alternative provides a unique risk return trade-off that is reflected in the EPS pattern. These results conflict with the commonly accepted intuition that increasing EPS through repurchase creates economic value for the investor. Our analysis can guide financial analysts in interpreting EPS changes that is, how to distinguish EPS changes that are associated with changes in expected shareholder wealth from EPS changes that are not. In general, EPS is positively correlated with firm performance; as operating performance improves, EPS also increases. As we demonstrated, however, this effect does not mean that all EPS increases are good news. Our analysis reinforces that the source of EPS changes must be understood to appropriately infer changes in the firm s core operating results. Firms like ExxonMobil repurchase shares with the declared intention of boosting EPS. For ExxonMobil, we showed that more than 16 percent of its EPS growth over the past four years is an artificial result of its repurchase program and cannot be associated with improvement in operating performance. An underinformed or naive analyst might inappropriately attribute this increase to enhanced operating efficiency and/or effectiveness. Similarly, we showed that the payout of dividends results in a decrease in EPS that should not be blindly associated with decreased operating performance. Our results have important implications beyond the effect of share repurchase on EPS. For example, many managers suggest that their firm repurchase shares to reverse the share dilution of employee stock and option compensation. Our results suggest that, although repurchasing shares prevents dilution of EPS, it does not prevent dilution of value to shareholders. The reason is that the granting of stock and option compensation does dilute value but repurchases do not enhance value. Another example applies to a practice that is gaining popularity among firms called accelerated repurchase. In an accelerated repurchase, the firm borrows a large quantity of shares from its shareholders through an investment banker and retires those shares upon receipt. Then, generally during a period of three to nine months, the investment banker buys shares on behalf of the firm in the open market and returns them to the lending shareholders. Accelerated repurchases enable a firm to quickly increase EPS while repurchasing shares slowly over time. 6 Our results imply that boosting EPS in this manner does not create value for shareholders. Our analysis adds to the evidence provided by other recent investigations. Cornell (25), for example, demonstrated that because repurchases change the number of shares outstanding, per share data are misleading. For instance, if the repurchased shares are reissued to employees, repurchases can actually reduce shareholder value. Fairchild (26) demonstrated the misconception that repurchases create shareholder value by spreading total market value over fewer shares. Jacob Oded is grateful to the Henry Crown Institute of Business Research in Israel for financial assistance. This article qualifies for 1 CE credit , CFA Institute

14 Stock Repurchases and the EPS Enhancement Fallacy Notes 1. For a review of the literature, see, for example, Allen and Michaely (23). 2. The increase in EPS under the repurchase policy is primarily driven by the reduction in the number of shares each period. Yet, given the accounting rules specifying the number of shares outstanding each year based on time weighting, a lag generally occurs in reported EPS. Under the cash accumulation policy, the firm reinvests all earnings each period. Because we are assessing payout policies, we assume that no funds are used for reinvestment in the firm s operations; funds are invested conservatively to accumulate cash and fund payouts to shareholders. Thus, the funds are invested in safe assets, yielding low growth in EPS. Under the policy of returning funds to shareholders through dividends, all earnings each year are paid out to investors, with the investor then being responsible for investing or otherwise using the proceeds. As a result, because the number of shares remains constant and all earnings are paid out, EPS remains constant over time. 3. To simplify, the earlier analysis did not consider taxes. The ExxonMobil example suggests that corporate taxes make dividend payouts and repurchases advantageous because the firm pays taxes on earnings from cash balances. At the personal level, however, investors pay taxes on capital gains and on dividend income (not considered in the example). Although the tax effects of payout policy on EPS are important, they are secondary to the main effect of payout policy on EPS, which, as we have argued and demonstrated, is misleading and does not add value for the firm or the shareholders. 4. Differences in per share amounts result from rounding. 5. Between January 22 and December 26, ExxonMobil s stock price increased from $4 to $8. In this sense, Exxon- Mobil made a good investment in itself. We have abstracted from information issues in our analysis. If shares were underpriced when ExxonMobil purchased them as part of its repurchase policy, then the firm and the shareholders who did not sell their shares to the firm benefited from the repurchase. If ExxonMobil s stock price drops to $2 tomorrow, however, because the shares were overvalued, the repurchase would mean loss of value to the firm s nonselling shareholders. Moreover, the policy of repurchase would create an economic loss. For example, between 1998 and 1999, US Airways spent $1.9 billion on its share buyback program. During this period, its share price dropped from $83 to approximately $25. Repurchases can enhance or reduce value if they are not performed at the firm s true value. Although information effects are important, they can work either way and, like taxes, are orthogonal to the main arguments of this article. 6. The firm incurs an obligation to absorb any subsequent share price changes. The alternative buying the shares quickly may adversely affect the market price and expose the firm to lawsuits that claim price manipulation. References Allen, F., and R. Michaely. 23. Payout Policy. In Handbook of the Economics of Finance. Edited by G. Constantinides, M. Harris, and R. Stulz. Amsterdam, Netherlands: Elsevier. Arnott, R., and C. Asness. 23. Surprise! Higher Dividends = Higher Earnings Growth. Financial Analysts Journal, vol. 59, no. 1 (January/February):7 87. Cornell, B. 25. Dividends, Stock Repurchases, and Valuation. Journal of Applied Finance (JAF), vol. 15, no. 2 (Fall/ Winter): Fairchild, R. 26. When Do Share Repurchases Increase Shareholder Wealth? Journal of Applied Finance (JAF), vol. 16, no. 1 (Spring/Summer): Grullon, G., and D. Ikenberry. 23. What Do We Know about Stock Repurchases? In The Revolution in Corporate Finance. 4th ed. Edited by J. Stern and D. Chew. Malden, MA: Blackwell Publishing. Grullon, G., and R. Michaely. 22. Dividends, Share Repurchases, and the Substitution Hypothesis. Journal of Finance, vol. 57, no. 4 (August): Miller, M., and F. Modigliani Dividend Policy, Growth, and the Valuation of Shares. Journal of Business, vol. 34, no. 4 (October): Pumping Cash, Not Oil. 27. BusinessWeek (28 May): b43657.htm?chan=search. Zhou, P., and W. Ruland. 26. Dividend Payout and Future Earnings Growth. Financial Analysts Journal, vol. 62, no. 3 (May/June): July/August

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