Stock Repurchases as an Earnings Management Device

Abstract

This paper investigates the role of earnings per share management in the decision to repurchase shares. We identify the conditions under which repurchases increase EPS and document the frequency of EPS increasing and EPS decreasing repurchases among U.S. firms from 1988 to 2001. We then compare the empirical distribution of EPS increasing and EPS decreasing repurchases relative to pre-repurchase forecast errors to examine whether EPS considerations appear to affect the repurchase decision. Finally, we examine the share price response to quarterly earnings announcements to determine how investors price the repurchase-induced component of reported EPS. We find evidence that a disproportionately large number of firms have EPS increasing repurchases when they would have marginally missed analyst forecasts without the repurchase, and a disproportionately small number of firms have EPS decreasing repurchases when they are close to analyst forecasts before the repurchase. Also, the market appears to discount the repurchase induced component of earnings surprise relative to the earnings surprise attributable to operations. Finally, firms that meet or exceed expectations only because of the repurchase receive approximately a 60% lower valuation premium than firms that meet or exceed expectations without a repurchase.

Keywords: Stock repurchases, earnings management, benchmarks

JEL Classification: G34, J33, M41, M43, G12, G29, G35