financial management accounting meets strategy: share
TRANSCRIPT
Fe b r u a r y 2 0 1 0 I S T R AT E G IC F I N A N C E 47
ILLU
STR
AT
ION
: A
RT
DIS
C
: Share Repurchase Programs
By Jane L. Reimers and J. Clay Singleton
If you’ve been a devoted reader of The New York Times
or The Wall Street Journal over the last few years, you’ve
undoubtedly read many articles about companies buying
back their own stock. According to a recent WSJ article,
aggressive share repurchases have been a significant
factor in allowing organizations to manage their capital
structure—the desired balance between debt and equity.
Although the recession has slowed the rate of share
repurchases, most experts think that repurchase programs
will continue to be popular. As recently as October 2009,
for example, IBM’s board of directors expanded the com-
pany’s share repurchase program, earmarking an addi-
tional $5 billion on top of the $2.6 billion IBM spent on
its own stock in its second and third quarters. Also, the
2008 edition of Accounting Trends & Techniques reported
that 65% of firms disclosed treasury stock—shares that
are issued but are not outstanding—on their 2007 balance
sheets, down only slightly from 68% in 2006.
The recession, therefore, has only slowed share repur-
chases. Even though, in the third quarter of 2009, stock
buybacks were down 61% from a year earlier, the
improvement over the second quarter—when expendi-
tures on buybacks hit their lowest level since 1998—was
an impressive 44%, according to The Wall Street Journal.
While in an economic downturn firms are concerned
with liquidity and often keep large cash balances, some
may have taken this too far and may start to reconsider
any decreases in share repurchases.
Over the past decade, treasury stock has become—and
continues to be—an increasingly important way of man-
aging the balance sheet. Integrating the underlying busi-
ness objectives with the accounting mechanics of buy-
backs provides an excellent example of strategic
accounting. As we’ve seen since the fall of Enron in 2001,
finance and accounting managers can’t have a myopic
focus on the rules and mechanics of accounting; they
must understand the firm’s objectives in engaging in spe-
cific transactions if they’re to communicate any confi-
dence in the company’s financial statements.
Accounting for Treasury StockThere are two acceptable ways to account for treasury
stock under Generally Accepted Accounting Principles
(GAAP): the cost method and the par value method. Let’s
take a closer look at each one.
The Cost Method. When a company uses the cost
method, the purchase of treasury shares is recorded at
cost in a contra-equity account called Treasury Stock. It’s
shown on the balance sheet at the end of the stockhold-
ers’ equity section as a deduction. Based on our research,
the cost method is the most prevalent method of
accounting for treasury stock. We examined companies in
both the S&P 500 (large-cap firms) and S&P 600 (small-
cap firms) to see how they account for share repurchases.
We found that 387 firms in the S&P 500 engaged in share
repurchases in each of three consecutive years (2005
through 2007). Of those firms, 78% used the cost
method. Among small-cap firms, 334 engaged in share
repurchases over the same time span, and, of those, 76%
used the cost method. Confirming the widespread use of
the cost method, the 2008 edition of Accounting Trends &
Techniques reported that 96% of the firms in its sample
that had treasury stock used the cost method to account
for it.
The Par Value Method. Of the firms that had trea-
sury stock transactions from 2005 through 2007, only
22% of the S&P 500 firms and 24% of the small-cap
companies we examined used the par value method. In
contrast to the cost method, when a company uses the
par value method there’s no Treasury Stock account on
the balance sheet. The cost of the repurchased shares is
deducted from paid-in capital accounts, and the shares
are treated as if they were retired. If the company pays
more than the original issue price for the shares, the
excess cost is deducted from retained earnings. Even
when a firm’s balance sheet shows no sign of treasury
stock, it’s still advisable to check the statement of share-
holders’ equity and the statement of cash flows to see if a
company is buying its own stock.
Rationale Behind Stock BuybacksHistorically, the most common reason for a firm to buy
its own stock is to maintain or achieve a certain level of
earnings per share (EPS). Although this may be the most
widely accepted reason, there are several more important
ones.
TRADITIONAL REASONS:
Distribution of Shares for Compensation Plans.
In their annual reports, most firms say they repurchase
shares to have them available for bonus and stock option
plans. But many companies repurchase more shares than
they issue. This trend is reflected in Tables 1 and 2, which
track stock issue and repurchase activity for companies in
the S&P 500 and S&P 600 indexes, respectively, from
2004 through 2008. If we accept the common explanation
that stock issuance was mostly driven by stock-based
compensation plans, the data shows a remarkable num-
ber of these companies repurchased much more stock
than they needed to cover current or future employee
stock options.
Earnings per Share. Some companies use share
repurchases to increase earnings per share or to at least
prevent the dilution of EPS by shares issued under equity
compensation plans. They hope that by decreasing the
number of shares outstanding—which in turn increases
EPS—the stock price will increase unrelated to any
change in earnings. Nevertheless, we believe that compa-
nies should buy back shares (or distribute dividends)
only when they can’t find better growth opportunities or
rates of return for their idle cash, not merely to boost the
stock price. While EPS will rise when there are fewer
shares outstanding, stock prices may not necessarily fol-
low if shareholders perceive the company to be sacrificing
cash that could instead be used to grow the business.
A Signal to Investors. Managers often believe that
their shares are undervalued, perhaps because their inside
information is more positive than the public perception
of the company’s relative strength. This problem is exac-
erbated by the difficulty of distinguishing between truth-
ful and overly optimistic management. Empirical studies
suggest that share repurchases occur about as often
among value stocks (presumed more likely to be under-
valued) as growth stocks. While none of the evidence
sheds much light on what motivates managers to repur-
chase shares, the debate over fair value will probably con-
tinue, and the question of whether share repurchases can
send a strong enough signal about underpriced stocks is
unlikely to be resolved anytime soon.
48 S T R AT E G IC F I N A N C E I Fe b r u a r y 2 0 1 0
FINANCIAL MANAGEMENT
STRATEGIC REASONS:
Excess Cash. Dividends have been the traditional way
to return cash to shareholders. Companies are hesitant to
reduce dividends because of the negative signal it sends
financial markets. But share repurchase programs are
much less visible and offer the company a valuable timing
option. For instance, if a company decides to change the
rate at which it repurchases stock, shareholders won’t
know about it until the next 10-K or 10-Q disclosure.
Even then, the company isn’t required to disclose changes
in the rate of implementation on an existing buyback
program.
Although companies may pay a dividend to get their
shares on institutional buy lists that screen for dividends,
they may well prefer share repurchases. The fact that
many companies have both suggests they value flexibility.
Research by Gustavo Grullon and Roni Michaely showed
that firms that repurchased their own stock didn’t see a
significant market reaction to dividend reductions,
whereas firms that cut their dividend without a repur-
chase program experienced a significant negative reac-
tion. These researchers concluded: “When investors
perceive that dividends are being replaced by repurchases,
they view the reduction in dividends as much less nega-
tive.” (For more on this topic, see “Dividends, Share
Repurchases, and the Substitution Hypothesis” in the
August 2002 issue of The Journal of Finance.)
During the past year or two, companies have kept
Fe b r u a r y 2 0 1 0 I S T R AT E G IC F I N A N C E 49
Table 1: S&P 500 Companies: Stock Sales and Repurchases
The figures in the top two rows of the table show that the majority of firms in the S&P 500 repurchased their own stock at a rate that
increased between 2004 and 2008. The bottom three rows of the table show that most of the firms repurchasing stock buy back much
more than they issue, a tendency that generally increased over the years studied.
Year 2004 2005 2006 2007 2008
Number of firms repurchasing stock 285 330 364 377 386
% of total 57% 66% 73% 75% 77%
Repurchases > Sales 76% 84% 88% 89% 88%
Repurchases 2x > Sales 49% 61% 72% 75% 72%
Repurchases 4x > Sales 28% 44% 48% 54% 62%
Table 2: S&P 600 Companies: Stock Sales and Repurchases
Compared to large companies, a smaller percentage of small-cap companies repurchased their stock, although the practice is still wide-
spread. The figures in the top two rows of the table show that the number of firms in the S&P 600 repurchasing their own stock increased
between 2004 and 2008. The bottom three rows of the table show that a substantial number of the firms repurchasing stock buy back
much more than they issue, a tendency that increased consistently over the years studied. Our conclusion—for large-cap companies and
small caps—is that these stock repurchases must have been motivated by something other than the need to cover current or future
employee stock options.
Year 2004 2005 2006 2007 2008
Number of firms repurchasing stock 208 233 250 288 346
% of total 35% 39% 42% 48% 58%
Repurchases > Sales 56% 63% 67% 73% 75%
Repurchases 2x > Sales 31% 38% 44% 51% 54%
Repurchases 4x > Sales 22% 25% 32% 38% 46%
higher cash reserves in response to the recession and an
uncertain economy. As the economy recovers, however,
there’s an ongoing discussion about what companies will
do with their extra cash. According to a recent article in
The Wall Street Journal, tech companies in particular need
to figure out “a better use for their expanding mountains
of cash.” For some industries, generating large amounts
of cash can create problems for the firm—takeover bids
from cash-hungry companies, for example. Keeping the
cash balance from getting too large helps protect a firm
from these types of takeover bids.
Capital Structure Maintenance. Another reason
for purchasing treasury stock involves a firm’s desire to
maintain a target capital structure. Finance experts often
debate whether or not there’s an optimal structure. Is
there a mix of debt and equity financing that’s just right
for a particular company? Some organizations believe
there is, and they use treasury stock purchases to main-
tain the desired balance between debt and equity.
Suppose a company’s debt remains constant. Two com-
mon events change the level of the firm’s equity: net
income and distributing stock to executives or employees.
First, consider what happens to the debt-to-equity posi-
tion of the firm when significant net income is earned.
The retained earnings account is increased by the amount
not paid out as dividends. To keep its relationship
between the book value of debt and equity stable, the
firm could buy treasury shares, which reduces equity
under both the par value method and the cost method of
accounting. Although paying dividends would accom-
plish the same thing, purchasing treasury stock is much
more flexible and controllable.
In contrast, when dividends are declared, payment
must follow. When a share repurchase plan is announced,
the repurchase is still optional. Paying dividends may also
create the expectation that they’ll continue.
Second, when shares of stock are issued to executives
and employees, paid-in capital is increased. But a pur-
chase of treasury shares can offset this increase in equity.
The flexibility inherent in this strategy is particularly
valuable because management can’t predict when
employees will exercise their options.
In addition to changing the amount of equity with the
purchase and sale of treasury stock, managers are also
changing the number of shares of stock outstanding. This
accomplishes several goals, including: (1) maintaining a
desired EPS, (2) avoiding a dilution of EPS when stock
options are exercised, (3) managing the amount of cash
needed to pay a dividend, and (4) managing float.
Required DisclosuresIn the United States, share repurchases are subject to a
number of regulations, especially those specified under
Securities & Exchange Commission (SEC) Rule 10b-18.
Because a firm may be accused of insider trading, this
rule provides a safe harbor for companies to avoid lia-
bility for manipulation when purchasing their own stock.
(As a practical matter, most firms elect to have a broker
manage the repurchase program so that purchase deci-
sions aren’t perceived to be influenced by the company.)
Effective December 2003, Rule 10b-18 requires that
companies disclose in their 10-K and 10-Q a table listing:
◆ All repurchases for the last fiscal quarter,
◆ Total number of shares purchased,
◆ Average price paid per share,
◆ Total number of shares purchased as a part of their
specific repurchase plan, and
◆ The maximum number (or approximate dollar value)
of shares that may yet be purchased under their plan.
Companies must also include a footnote describing the
terms of all publicly announced repurchase plans, includ-
ing the date each was announced, the share or dollar
amount approved, and the expiration date (if any). Share
repurchase plans can be completed before the expiration
date, or the date can be extended. For example, Costco
authorized a share repurchase program in 2001 to buy
back up to $500 million of its common stock through
November 2004 (renewed through 2007), but the com-
pany didn’t purchase any shares until after August 2005.
Some Recent Repurchase ProgramsDividend Equivalent of a Share Repurchase. Dard-
en Restaurants, parent company to popular chains like
Olive Garden and Red Lobster, actively repurchases its
own shares and also pays dividends to its shareholders.
We can calculate the dividend equivalent of the firm’s
share repurchases with information provided in the com-
pany’s annual report. In fiscal 2008, Darden repurchased
five million shares at a cost of $159.4 million. With
140.4 million common shares outstanding at the begin-
ning of the fiscal year, the share repurchase amounted to
a dividend of $1.135 per share (159.4/140.4). Compared
to a cash dividend declared of $0.72 per share, the buy-
back program was definitely significant.
Merck provides another example of how impactful
share repurchases can be. In fiscal 2008, Merck bought
back 69.5 million shares for $2.725 billion. The compa-
ny had approximately 2.172 billion shares outstanding
during the year, which paid cash dividends of $1.52 per
50 S T R AT E G IC F I N A N C E I Fe b r u a r y 2 0 1 0
FINANCIAL MANAGEMENT
share. The share repurchase, on the other hand, provid-
ed an additional dividend equivalent to $1.25 per share
(2,725/2,172). Although the cash dividend was greater
than the stock repurchase equivalent, another $1.25 per
share was a very significant increase in the per-share
dividend.
Share Repurchases and the Increase in EPS. As
mentioned earlier, in its 2008 annual report Darden
Restaurants reported an average of 140.4 million common
shares outstanding for the year ended May 25, 2008. Net
earnings for the 2008 fiscal year were $377.2 million.
During the year, Darden purchased five million shares of
treasury stock. Suppose, though, that the firm hadn’t
repurchased any of its own shares during the year. With no
change to earnings, what would the reported EPS look like?
◆ Reported earnings of $377.2 million divided by
140.4 million shares = $2.69 per share, as actually
reported.
◆ Reported earnings of $377.2 million divided by
140.4 (+ 5) million shares = $2.59 per share if the
shares had not been repurchased, making the denomi-
nator larger. EPS would have been smaller by $0.10
per share.
Another example of an increase in EPS because of
share repurchases comes from Books-A-Million. For the
fiscal year ended January 31, 2009, Books-A-Million
reported net income of approximately $10.6 million and
had an average of 15.2 million shares of common stock
outstanding. During the year, the firm purchased 239,000
shares of treasury stock. Suppose Books-A-Million hadn’t
repurchased any of its own stock. With no change to
earnings, the reported EPS for the fiscal year would have
been $0.01 smaller. Anyone who watches earnings
announcements knows that even a penny can make a dif-
ference in whether the company’s earnings meet analysts’
expectations.
◆ Reported earnings of $10.6 million divided by
15.2 million shares = $0.69 per share.
◆ Reported earnings of $10.6 million divided by
15.2 (+ 0.239) million shares = $0.68 per share.
The Bottom LineShare repurchases have become increasingly popular as
companies decide how best to use their cash surpluses.
Although not often discussed in terms of a company’s
strategy, treasury stock transactions are important and
have implications for the value of the firm. When the
accounting and economic issues are understood, share
repurchases convey valuable information to shareholders,
securities analysts, and corporate treasurers. Moreover,
buybacks provide management accountants with a flexi-
ble tool for managing leverage and distributions to share-
holders. Both securities analysts and shareholders should
recognize treasury stock transactions as an important
component of shareholder value. SF
Jane L. Reimers, Ph.D., is a professor of accounting in the
Crummer Graduate School of Business at Rollins College in
Winter Park, Fla., and a member of IMA. Before joining the
Crummer faculty in 2003, she was the KPMG Professor at
Florida State University. You can reach her at (407) 646-
2499 or [email protected].
J. Clay Singleton, Ph.D., is a professor of finance in the
Crummer Graduate School of Business at Rollins College.
Before joining the Crummer faculty in 2001, he was vice
president of Ibbotson Associates, where he was responsible
for the firm’s consulting, training, and research activities.
You can contact him at (407) 691-1229 or
Fe b r u a r y 2 0 1 0 I S T R AT E G IC F I N A N C E 51
FURTHER READING
For more information about stock repurchases, here’s
a list of the articles we mentioned in the text.
Accounting Trends & Techniques, 2008 edition, pub-
lished by the American Institute of Certified Public
Accountants (AICPA), www.cpa2biz.com.
Kerry Grace and Rob Curran, “Stock Buybacks
Plummet,” The Wall Street Journal, March 27,
2009, p. C9.
Gustavo Grullon and David Ikenberry, “What Do We
Know about Stock Repurchases?” Journal of
Applied Corporate Finance, Spring 2000,
pp. 31-51.
Gustavo Grullon and Roni Michaely, “Dividends,
Share Repurchases, and the Substitution
Hypothesis,” Journal of Finance, August 2002,
pp. 1649-1684.
Martin Peers, “Tech Companies Need a Cash Plan,”
The Wall Street Journal, March 21, 2009, p. B10.
Karen Richardson and Gregory Zuckerman, “Where
Have Buybacks Gone?” The Wall Street Journal,
January 24, 2008, p. C1.
Jason Zweig, “Corporate-Cash Umbrellas: Too Big for
This Storm?” The Wall Street Journal, March 14,
2009, p. B1.