Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance

Abstract

Classic signaling theory suggests that in an economic environment which results in a pooling equilibrium, investors who have difficulty ascertaining firm quality should expect managers in low-quality firms to occasionally mimic valuation signals otherwise associated with high-quality firms. Few papers have empirically validated this simple, well-established idea. As such, we consider open market share repurchases, a transaction long held in suspicion as lacking the credibility of a costly signal, and thus potentially susceptible to mimicking.

No clean measure of managerial intent exists; program size and ex-post completion rates are ineffectual in the context of this transaction. Instead, we use earnings quality as a noisy proxy. Firms which aggressively employ discretionary accruals, particularly those which also show lagging stock performance, exhibit traits which suggest that executives may have been under pressure to boost stock prices. Using this measure, we ex-ante identify a set of firms which, while benefiting in the short-term from a buyback announcement, do not show the same improvement in post-announcement operating and stock performance otherwise observed.

Consistent with simple notions of signaling theory, this evidence suggests that some open market buybacks may be announced with the intent of manipulating investor opinion. While not complete, this paper provides some insight into the more general empirical phenomenon of underreaction; some level of investor skepticism about this type of corporate announcement is justified.

Keywords: share repurchases, discretionary accruals, earnings quality, price manipulation

JEL Classification: G10, G30, M40