Capital Markets

Are Buybacks Really a Bargain?

How deliberately deflating earnings might be helping some companies boost their share price.
Alan RappeportMarch 8, 2007

When CBS announced this week that it would buy back $1.4 billion worth of stock, its sagging share price saw the biggest spike since the media giant parted ways with Viacom in 2005. The 4.5 percent jump may be an omen of good fortune — at the very least, it shows how much shareholders like buybacks.

Companies have been gobbling up their own shares faster than ever in a world of cheap capital and swollen balance sheets. But some have questioned the moves and motives that lead up to a big buyback.

Companies buy their own shares for any number of reasons. In addition to simply returning cash to shareholders, they also typically say they do so because they believe their stock is undervalued, and its price doesn’t accurately reflect the company’s performance. Yet new research shows that companies often use creative financial reporting to push earnings downward before buybacks, making the stock seem undervalued and causing its price to bounce higher after the buyback. That pleases investors, who then amplify the effect by pushing the price even higher.

“Managers who are acting opportunistically can use their reporting discretion to reduce the repurchase price by temporarily deflating earnings,” argue Guojin Gong, Henock Louis and Amy Sun, of Penn State University’s Smeal College of Business, in a paper forthcoming in the Journal of Finance. The authors say companies can easily create an apparent slump by speeding up or slowing down expense recognition, changing inventory accounting, or revising estimates of bad debt — all classic methods of making the numbers look worse without actually breaking accounting rules.

Observing data from 1,720 companies from 1984 until 2002, the authors show that the appearance of improved profitability after a buyback is not necessarily the result of better performance, but rather the effect of weak earnings reports before the buyback is announced. The paper asserts that managers stand to gain by holding onto shares with rising values, and earnings are more heavily managed if the CEO holds more shares and has more to gain. If intentional, such a charge could be damning.

“The rules allow the managers the discretion” says Professor Louis. “I think they do it intentionally.”

Still, some question whether the relationship is causal or coincidence. Many companies use buybacks to prop their stock in the wake of bad news. Such behavior has been common in the last few years. Since 2003 the market for buybacks has boomed, with repurchases nearly on a par with capital expenditures. “Now is a totally different environment,” says Howard Silverblatt, an analyst at Standard and Poor’s. “Today we have so much excess liquidity.”

That liquidity has fueled the surge in stock repurchases. In 2006, $437 billion of stock was repurchased, according to Silverblatt. The amount of stock repurchased in the fourth quarter of 2006 is nearly triple the amount repurchased during the same period in 2003. Silverblatt is not convinced that the majority of those companies were intentionally managing earnings. “Did companies do it constantly, or were they one-shot deals?” he asks. “We have not been able to find a smoking gun.”

Certainly, the penalty these days for being caught deliberately managing earnings in advance of a buyback would be severe. With new backdating scandals popping up weekly, executives would no doubt be wary of deflating earnings just to get a bigger boost from a buyback.

Still, that’s what Louis thinks they’re doing. “I don’t think what they’re doing is illegal,” he says. “But it’s misleading their investors.”