The Influence of Treasury Stock

Purchases on Growth of Firm Market

Value
Richard L. Alltizer, Ph.D., CPA
Assistant Professor of Accounting Introduction
University of Central Oklahoma During the decade of the 1990s, publicly traded companies
100 North University Drive escalated share repurchases (Kahle, 2002). The common reasons
Edmond, OK 73034 to repurchase stock include distributions to shareholders;
acquisitions of another company; reduction of the opportunity
Katherene P. Terrell, Ed.D., CPA for a hostile takeover; reduction of the dilutive effect on
Professor of Accounting
Earnings per Share (EPS) from the issuance of stock options,
University of Central Oklahoma
warrants, and convertible issues; or an effective increase in the
100 North University Drive
market price of the common stock.
Edmond, OK 73034
Stock repurchases reduce the capacity of the firm to finance
Robert L. Terrell, Ed.D., CPA, CIA, CFE its operations through positive net present value investments.
Professor of Accounting Since operating revenues represent the only renewable source of
University of Central Oklahoma earnings for the entity, a firm forfeits its highest earning capacity
100 North University Drive in favor of zero-earnings produced by the reduction in equity.
Edmond, OK 73034 In the case of a threat of a hostile takeover, the loss of earnings
to thwart the takeover may be worthwhile. Otherwise, the
Barbara Parrish, Ph.D., CPA opportunity costs of distributions through repurchases may be
Professor of Accounting detrimental to the long-term financial health of the organization
University of Central Oklahoma by reducing the future growth of operating revenues and EPS.
100 North University Drive Consequently, lowering the numerator of the EPS calculation
Edmond, OK 73034 may eventually negate the positive effect that the share buyback
has on the EPS calculation denominator.
Ralph W. Parrish, Ph.D. A corporation may legally repurchase its common stock
Associate Professor of Management provided that the repurchase complies with existing state
University of Central Oklahoma laws. Some current state laws require that repurchased stock
100 North University Drive be retired, a requirement that may cause major reductions in
Edmond, OK 73034 retained earnings (equal to the number of shares repurchased,
multiplied by the difference between the original issue price
Abstract of the stock and the repurchase price). For example, if shares
While stock repurchases have long been considered of stock originally sold for $5 and are currently priced at
an effective business and tax strategy for relatively small $20, the retirement reduces retained earnings by $15 for each
closely-held corporations, larger publicly-traded corporations share of stock purchased. The reduction of retained earnings
historically used the technique less often. However, during cannot be replaced even if the stock is resold for more than
the decade of the 1990s, large publicly-traded firms began $20 per share. The retirement of stock is a return of capital
repurchasing outstanding common stock at record rates, while to a limited number of shareholders. Certainly the reduction
at the same time employee stock options reached record highs. of retained earnings precludes declaration of dividends by
Prior research partially explains the increase in redemptions those amounts to the remaining stockholders. By how much
as a corporation’s means of controlling the dilutive effect on does the market price have to rise to offset the permanent loss
earnings per share (EPS) arising from outstanding or exercised of dividend capacity? This begs the question of its effect on
stock options. This study examines the relation between stock the total market value of the corporation over time when the
repurchase activity and changes in firm market value. In Board of Directors authorizes significant share repurchases.
general, we find, among a subset of the Fortune 500 during the To empirically determine the effect that net share repurchases
1990s, stock repurchases are aligned with lower market value had on firm total market value, we examined the 1992 Fortune
growth during that period. 500 companies from 1992 to 2000.

24 CENTRAL BUSINESS REVIEW • VOLUME XXVIII NO. 1-2

 Prior Research
Management experiencing significant free cash flows has
several opportunities to use the cash: investment in projects;
distributions to shareholders; share repurchases; and mergers
and acquisitions (Jensen, 1986; Barth & Kasznik, 1999;
Dittmar, 2000; Weisbenner, 2000; Lee & Alam, 2004; Fenn &
Liang, 2001; Bens, Nagar, & Wong, 2002; Kahle, 2002; Bens,
Nagar, Skinner, & Wong, 2003; Brav, Graham, Harvey, &
Michaely, 2005; Wilber, 2007). Selection among alternatives
becomes a critical factor in both the short-term and long-term
financial health of the firm.
Investment in key projects becomes the life blood of future
profitability. Bens et al. (2003) defined the opportunity cost
of share repurchases as a reduction in future earnings because
the repurchase leads to decreased firm investments or increased
borrowings. Bens et al. (2003) studied 357 firms from 1996-
1999 with hand-collected data from 10K filings. The authors
found that undervalued firms that generated large positive cash
flow from operations would be most likely to use excess cash
to repurchase shares. Bens et al. (2002) studied a sample of
Standard & Poors’ 500 firms from 1996 to 1999, and found
that stock option exercises cost companies because they forego
profitable investments, such as research and development in
favor of stock repurchases to enhance EPS, which in turn
has a negative impact on future earnings. Bens et al. (2002)
findings confirm that stock option exercises temporarily reduce
discretionary investments and show weak evidence that the
reduction of investments diminishes subsequent returns on
assets.
Bens et al. (2003) also raise the issue of the likelihood that
executives manage earnings per share through the denominator
of the EPS equation with share repurchases. Likewise, Core
Guay, and Kothari (2002) studied a sample of firms from 1994
to 1997 and found weak evidence that the FASB calculation of
dilution underestimates the dilution factor. Core et al. (2002)
assert that the denominator of the EPS calculation required in
SFAS No. 128 fails to adequately disclose the dilution of EPS.
They further hypothesize that option holders and shareholders
have claims on earnings of the firm and share the capitalized
value of the firm’s earnings.
Brav et al. (2005) surveyed 384 financial executives and
found that, in cash distribution decisions, managers give
historical dividends first priority, good investments second, and
repurchases third priority. In addition, Brav et al. (2005) and
Jagannathan, Stephens, & Weisbach (2000) found that managers
prefer share repurchases because that strategy gives them more
flexibility in market timing and can be used to increase earnings
per share. Retail investors prefer dividends but institutional
investors are indifferent to dividends or repurchases (Brav et
al., 2005). Executives valued repurchases to offset dilution
from stock options. When executives were asked if they could
start over, the findings of Brav et al (2005) indicated managers
would minimize dividends and select repurchases to return
capital to investors. Likewise, Jagannathan et al. (2000) found
firms with long-term high operating cash flows pay dividends,
while firms with high short-term investing or financing cash
flows repurchase shares.
UNIVERSITY OF CENTRAL OKLAHOMA • WINTER-SUMMER 2009
Weisbenner (2000) posits the undo-dilution hypothesis
indicating that firms systematically repurchase shares during
the lifecycle of executive stock options to undo most of the
EPS dilution from the options. He believes repurchases distort
the true cost of stock compensation plans, because cash wages
reduce earnings immediately, and much of the cost of stock
options is not reported on the income statement. The cash
effects between cash wages and stock options differ, however,
and provide topics for ongoing research. Lee and Alam (2004)
sampled 545 firms from 1996 to 2000 and found support for
the undo-dilution hypothesis for employee stock option plans.
Wilber (2007) found that some firms decide to acquire a
company by repurchasing its own shares and use the treasury
stock instead of cash for the acquisition funding, in contrast
to conventional wisdom that cash purchases perform better
(Martin, 1996). Bartov (1991) found unexpected positive
earnings associated with a repurchase announcement in the
announcement year, plus analysts increased earnings forecasts
for those companies. (According to Wilber’s (2007) findings,
96 firms that financed acquisitions with repurchased stock from
1995 to 2002 showed positive cumulative abnormal returns
for second and third years post-announcement instead of the
normal negative returns experienced in cash acquisitions. These
returns were primarily due to tax considerations of purchase
accounting.) Wilber (2007) indicated that most firms using
the repurchase financing method were undervalued, had cash
available, and had positive earnings. Dittmar (2000) asserts
that most repurchasing firms are taking advantage of potential
undervaluation. In a study of firms repurchasing share in the
open market from 1990-1994, Barth and Kasznik (1999) also
concluded that firms heavily invested with intangible assets,
and likely undervalued, prefer share repurchases.
The current study examined companies ranked in the
Fortune 500 in both 1992 and 2000. We selected a time when
the stock market experienced a nine-year period of growth
with few economic shocks. Many of the studies previously
conducted were for five-year periods. Our approach examines
whether the overall market capitalization for these firms varied
with respect to the level of net cash outflows to repurchase
shares. Core et al. (2002) gave hint to the market capitalization
being shared by shareholders and option holders. The evidence
of our study indicates that companies with lower net cash
outflows for share repurchases grew at a faster rate from 1992
through 2000 than companies investing more cash in share
repurchases.
Methodology
Sample Selection
We selected a subset of the Fortune 500 for this study.
The sample consists of all firms making the list for 1992 and
remaining on the list through 2000. One hundred seventy-six
of the original 500 listed were still on the list in 2000. Next,
we removed from the sample firms with incomplete or missing
data, resulting in the loss of an additional 53 firms. The final
sample consists of 123 firms.
25
Hypotheses
As previously discussed, companies cite a variety of Table 1
Descriptive Statistics (in Millions)
reasons for repurchasing their stock on the market. Among (n=123)
the reasons, many companies justify the purchase by asserting
a probable increase in market value. However, if a company Variable High Low Mean
reduces its working capital for non-income producing share Net Share Repurchases (NSR) $-34,557.00 $5,408.30 $-1,926.76
repurchases, its market value may diminish. We examined NSR as Function of Equity -10.66 2.40 -.51
these competing contentions by testing the change in market Market Value - Beginning 74,995.10 130.80 7,830.24
value as a function of share repurchases activity. Thus, the Market Value - Ending 417,175.10 301.70 26,904.77
hypothesis is: Average Total Equity 33,641.20 -789.77 4,292.10
Percentage change in Market Value 12,888% -61% 373%
H1: Net cash outflows for share repurchases will accompany
a change in firm market value. Where:
NSR = the net of sales and purchases of common stock for each year summed
A review of the raw data revealed that some firms have over the study period.
high/low share repurchase activity that is inversely related to NSR/ Equity = NSR divided by the average equity for each firm in the sample
their level of stockholders’ equity. Thus, we included a second over the study’s timeline.
test taking into account net share repurchase activity as a Market value = the company’s market value as reported by Fortune Magazine
function of stockholders’ equity. Hypothesis two incorporates when ranking the “Fortune 500.”
Average Total Equity = the nine year average of each company’s equity as
stockholders’ equity which indirectly includes common shares reported on their annual financial statements..
outstanding and retained earnings.
H2: Net cash outflows for share repurchases, weighted by
stockholders’ equity, will accompany a change in firm
market value. Table 2
Market Value Sorted by Net Share Repurchase Activity
Full Sample
Data Selection
Using the Securities and Exchange Commission’s Edgar Variable N Percentage change in
database, we accessed the annual financial statements for each Market Value
company and year in our study period, 1992 through 2000. We High S/R Activity 61 267.0
retrieved the net share repurchase activity and total equity for
each year, and use this information to calculate our test variables Low S/R Activity 61 483.6
as discussed below. The Fortune 500 lists for 1992 and 2000 Test on difference in means, t = .928
provided each company’s beginning and ending market values.
Subtracting beginning market value from ending market value,
and dividing the change by beginning market value, yielded a A review of the raw data presents a clear and compelling
percentage change in market value to standardize the change. difference between the upper third and lower third of the
By standardizing the change in market value, we obtain a more sample. Therefore, to refine the test, we partitioned the sample
comparable measure of the changes for further analysis. into three parts, and tested the high and low subsets. Again,
To compute a measure of share repurchase activity, the the test compared the mean percentage change in market value
sum of the annual net share repurchase (NSR) activity was between the subsets. (See Table 3.) The difference in means
computed for each company. This variable incorporates both increased from 222.8 percent to 669.8 percent, and this test
share purchases and the sales or issuance of common stock is statistically significant (t = 1.35). Based on our analysis, it
(Cash outflow for stock repurchases less cash inflow from stock appears that companies engaging in share repurchases in an
sales). The data were gathered from each company’s annual effort to boost market value are engaging in a failed strategy.
Statement of Cash Flows. Table 1 presents the descriptive In fact, based on our sample, the companies with lower share
statistics for the sample. repurchase activity had a much higher percentage increase
in market value than those companies engaging in relatively
Results higher share repurchases.
The first test examined hypothesis one. (See Table 2.) We
partitioned the full sample into high and low share repurchase Table 3
activity. A test on the difference in means was employed to Market Value Sorted by Net Share Repurchase Activity
measure differences between firms with large cash outflows Partitioned Sample
for net stock repurchases versus firms with relatively lower Variable N Percentage change in
cash outflows. (Some companies made no share purchases, Market Value
but issued additional common stock; thus, these firms had
a net cash inflow). While we find a quantitative difference High S/R Activity 41 222.8
between the two subgroups, 267 percent change compared Low S/R Activity 41 669.8
to 484 percent change, the mean change is not statistically
significant (t = .928). Test on difference in means, t = 1.35

26 CENTRAL BUSINESS REVIEW • VOLUME XXVIII NO. 1-2

 The second hypothesis asserts that share repurchase activity
weighted by average stockholders equity will affect market
value changes. Because prior research presents a variety of
rationales for share repurchases and the reasons may have
conflicting outcomes, we again do not predict a directional
change. The first test performed on the weighted share
repurchases included the full sample. (See Table 4.) Unlike the
previous full sample test, the test reveals a significant difference
between the percentage change in market value between the
two subsets (t = 1.34). Companies with relatively high share
repurchases have a percentage increase of only 219.0 percent
compared to 529.5 percent for the companies with a smaller
amount of net share repurchases.
Table 4
Market Value Sorted by Weighted Share Repurchase Activity
Full Sample
Variable N Percentage change in
Market Value
High S/R Activity 61 219.0
Low S/R Activity 61 529.5
Test on difference in means, t = 1.34
The last test compared the weighted share repurchase
variable employing the highest and lowest thirds of the sample.
(See Table 5.) The change in percentage market value for the
subsets is 224.8 percent for the highest share repurchase activity
and 637.5 percent for those with the lowest activity. Again,
the difference in means is significant (t = 1.24), and supports
the previous tests.
Table 5
Market Value Sorted by Weighted Share Repurchase Activity
Partitioned Sample
Variable N Percentage change in
Market Value
High S/R Activity 41 224.8
Low S/R Activity 41 637.5
Test on difference in means, t = 1.240
Our analysis indicates that excessive share repurchase
activity does not appear to be a useful strategy for firms wishing
to enhance their market value. While we understand that
industry membership, maturity of the firms and other variables
not included in our study may impact the results, large scale
share repurchases appear counter-intuitive when growing firm
market value is the desired outcome. Our intention is to further
refine this study by gathering additional data and expanding
the tests.
UNIVERSITY OF CENTRAL OKLAHOMA • WINTER-SUMMER 2009
Summary and Conclusion
The decade of the 1990s ushered in an era of much higher
share repurchase activity by a significant portion of the publicly
traded companies. While the market as a whole experienced
a large increase in market value as evidenced by the change in
the Dow Jones Industrial Average (which began at 2,610.64
points and ended at 10,787.99 points during our study period),
our sample did not match the general change in the market as
evidenced by the growth in the Dow. More specifically, we
find that a sample of Fortune 500 companies with relatively
high share repurchase activity experienced a smaller increase
in market value than those firms with relatively lower levels of
share repurchase activity. Furthermore, the change in market
value is inversely correlated with share repurchase activity.
Thus, our findings suggest that a strategy to improve market
value with share repurchases is counterproductive.
References
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Bartov, E. (1991). Open-market stock repurchases as signals
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stock options, EPS dilution, and stock repurchases.
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About the Authors
Richard Alltizer, is a certified public accountant with
more than 14 years of public accounting experience, has an
extensive background in technical tax research, and is active
in several professional organizations. Dr. Alltizer earned a
Master of Accountancy (in taxation) and a Ph.D., both from
the University of Oklahoma. He has previously published in
numerous journals, for example: American Business Review,
Oil & Gas Tax Quarterly, Taxation for Accountants, and Taxes.
E-mail: ralltizer@uco.edu
Barbara Parrish holds a Ph.D. in Accounting from the
University of Arkansas. She is a Professor of Accounting at
the University of Central Oklahoma and is a Certified Public
Accountant. She has previously published in the Journal
of Accounting Education, Government Finance Journal,
NAPM Insights, and numerous conference proceedings.
She has authored Mastering the Accounting Cycle (with Dr.
Mary Sheets) and serves as reviewer for Journal of Business
Strategies.
E-mail: bparrish@uco.edu
Ralph W. Parrish earned a Ph.D. in Management from
the University of Arkansas – Fayetteville. He is an Associate
Professor and Assistant Chair of the Management Department in
the College of Business at the University of Central Oklahoma
and a Certified Internal Auditor. He has previously published
in the Delta Business Review and numerous conference
proceedings. His research interests include decision making
and the interrelationships between financial reporting and
business strategy. He serves as a reviewer for the Journal of
Business Strategies and Central Business Review.
E-mail: rparrish@uco.edu

Katherene P. Terrell, Ed.D., CPA is a Professor of

Accounting and Chairperson of the Accounting Department
at the University of Central Oklahoma. Specializing in
Financial Accounting, she has co-authored a number of
accounting textbooks and ancillaries. Dr. Terrell has received
numerous teaching and service awards including the Oklahoma
Outstanding Accounting Educator award and the first Modeling
the Way award. Dr. Terrell had a 22 year career in public
accounting before entering her academic career.
E-mail: kterrell@uco.edu

Robert L. Terrell, Ed.D., CPA, CIA, CFE is a Professor of

Accounting at the University of Central Oklahoma teaching in
the areas of Auditing, Fraud, Ethics, and Financial Accounting.
He has co-authored numerous accounting textbooks. Dr.
Terrell has received the Oklahoma Outstanding Accounting
Educator award and the Carnegie Foundation 2008 Oklahoma
Professor of the Year award, among many others. He practiced
in public accounting for 23 years and provides many continuing
education seminars.
E-mail: rterrell@uco.edu

28 CENTRAL BUSINESS REVIEW • VOLUME XXVIII NO. 1-2