Boom time for share buybacks

But are company managers motivated by greed or creating shareholder value?

Once the sole domain of US companies, the fashion for share buybacks is now catching on with their UK counterparts in a big way. For example, between January 1995 and December 2000, UK firms spent a whopping �34 billion repurchasing their own shares. Firms returned a staggering �9 billion to shareholders through various buyback programmes in the year to December 2000 alone, an increase of over 600 percent on the aggregate value of buybacks made in 1995. Yet despite their increasing economic significance, their motivation and impact remain controversial.

If buybacks are perceived to create value for shareholders, then share prices should respond positively to the news that a buyback is on the cards. After adjusting for market and risk factors, Young and Oswald find that share prices rise by 2 percent on average when companies announce they are considering implementing a buyback. So UK investors appear to view buybacks as value-creating transactions.

But why are firms increasingly using share buybacks to return large amounts of cash to owners and why do investors interpret such actions so favourably?

Wouldn't it be better if firms were instead using these resources to invest and build for the future?

A popular explanation for buybacks is that they enable firms with poor investment opportunities to pay out surplus cash rather than wasting it on value-destroying projects. Because these excess cash flows tend to be fairly volatile, buybacks represent a more flexible mechanism for returning funds to shareholders than dividends.

Take for example the retail banking sector where low interest rates, low inflation and internal restructuring have strengthened balance sheets to the point where excess capital has become a major problem. The response of firms such as Barclays has been to return huge sums to shareholders through buybacks. Indeed, over a quarter of all firms cite this explanation among their list of reasons for implementing buybacks.

But by far the most frequently cited motive -- mentioned by nearly half of all firms -- is the desire to increase earnings per share (EPS). The logic goes as follows: buybacks reduce the number of shares outstanding; this increases the earnings available for each share; and this leads to a higher analyst rating. If only life was so simple!

And if that wasn't bad enough, the prevalence of EPS-based performance measures in executive compensation plans hints at a more sinister motive: managers may be using buybacks to maximise their compensation rather than to create value for shareholders. No wonder some in the investment community view these transactions with a degree of scepticism.

Part of the recent growth in buyback activity can be traced to changes in taxation. Buyback activity increased sharply following the abolition of dividend tax credits in July 1997, after which point buybacks and dividends were placed on a level playing field for tax purposes. The attractiveness of buybacks was further enhanced in April 1999 following the abolition of Advance Corporation Tax (ACT). Prior to this date, standard buyback methods such as open market repurchases qualified as distributions for tax purposes and as such gave rise to a higher ACT charge.

For further information, contact Dr. Steven Young on 44-152-459-4242 (email: [email protected]) or Professor Dennis Oswald on 44-207-262-5050 (email [email protected]).

Or Iain Stewart or Lesley Lilley at ESRC, on 44-179-341-3032/413119 or email: [email protected] or [email protected].

NOTES FOR EDITORS:
1. The research report 'Share Repurchases in the UK: Motives and Shareholder Wealth Effects' by Steven Young and Dennis Oswald was funded by the Economic and Social Research Council (ESRC).

2. Steven Young is in the Department of Accounting & Finance, The Management School, Lancaster University, Lancaster LA1 4YX; Dennis Oswald is at London Business School, Regent's Park, London NW1 4SA.

3. The ESRC is the UK's largest funding agency for research and postgraduate training relating to social and economic issues. It has a track record of providing high-quality, relevant research to business, the public sector and Government. The ESRC invests more than �46 million every year in social science research. At any time, its range of funding schemes may be supporting 2,000 researchers within academic institutions and research policy institutes. It also funds postgraduate training within the social sciences, thereby nurturing the researchers of tomorrow. The ESRC website address is: http://www.esrc.ac.uk

4. REGARD is the ESRC's database of research. It provides a key source of information on ESRC social science research awards and all associated publications and products. The website can be found at http://www.regard.ac.uk.