Aurora Borealis
1 April 2015 CFA Institute Journal Review

Capital Structure, Equity Mispricing, and Stock Repurchases (Digest Summary)

  1. Imrith Ramtohul, CFA

Firms repurchase shares for many reasons. A share repurchase changes the capital structure of the firm, and this adjustment can enhance a firm’s value, especially if it is both underleveraged and undervalued. Stock investors particularly value the repurchase plans of firms that are undervalued. Firms most likely will not announce a share repurchase when they are both overleveraged and overvalued.

What’s Inside?

Although firms announce repurchases for many reasons, the authors find that market reactions to open market share repurchases are magnified if the firm is both underleveraged and undervalued. In contrast, the market will discount repurchase announcements by overleveraged and overvalued firms. Therefore, adjusting the capital structure can be value enhancing, and the extent of this enhancement will depend on the firm’s undervaluation. It seems that many firms recognize this relationship and consider their leverage and valuation when choosing whether to announce a repurchase. The likelihood of issuing new shares is thus higher when the firm is overvalued and overleveraged.

How Is This Research Useful to Practitioners?

The authors extend previous research that investigated market reactions to share repurchases by studying the association among stock returns and repurchase announcements and capital structure policy. They find that market reactions to open market share repurchases are magnified if the firm is both underleveraged and undervalued. The authors’ results prove to be robust to different methods of measuring equity repricing and alternative definitions of leverage as well as to the inclusion of controls for certain well-known determinants of share repurchases.

Using the market debt ratios and residual income model, they find that the announcement returns are 1.5% greater for underleveraged and undervalued firms when compared with overvalued and overleveraged firms, even after considering other possible reasons for share repurchases. Firms also recognize that the interaction between capital structure and valuation affects the added value that was created through share repurchases. As a result, they will most likely announce a share repurchase when the firm is underleveraged and undervalued. The extent to which adjusting capital structure will create value for a share repurchase depends highly on the undervaluation of the firm. Similarly, the authors expect the likelihood of issuance of new equity to be higher in the case of overleveraged and overvalued firms.

Portfolio managers, corporate finance managers, and equity analysts will find the conclusions of this research useful. Announcing a share repurchase will be more value enhancing if the firm is undervalued and underleveraged. In contrast, overvalued and overleveraged firms may be expected to issue shares.

How Did the Authors Conduct This Research?

The authors analyze 7,880 open market share repurchase announcements reported in the Securities Data Corporation (SDC) Repurchases database between 1990 and 2010 using return data from CRSP and accounting data from Compustat. Companies subject to regulatory capital structure requirements are excluded. The number of repurchase announcements increases during the economic expansion of the late 1990s; they decline until 2003, and increase again until 2008, ending with a sharp drop in 2009.

The authors present three-day cumulative abnormal returns (CARs) around repurchase announcements using an event-study method. They estimate the market model over 255 trading days ending 46 days prior to the announcement using the CRSP value-weighted index as a proxy for market returns. Median CARs range from just less than 1% to a little more than 3%.

The authors estimate equity misvaluation using two methods: the residual income model and a model that breaks down the market-to-book ratio into separate mispricing effects. They estimate the target capital structure using a dynamic model based on Blundell and Bond (Journal of Economics 1998). Using univariate and multivariate comparisons, they find that announcement returns associated with share repurchases are smallest for the overleveraged/overvalued firms (1.8%), followed by underleveraged/overvalued firms (2.4%), overleveraged/undervalued firms (2.7%), and then underleveraged/undervalued firms (3.3%).

Undervalued and underleveraged firms are significantly more likely to announce a repurchase under both methods of valuation. Overleveraged and overvalued firms are less likely to engage in a share repurchase. The authors also highlight that the empirical results of being underleveraged and overvalued or overleveraged and undervalued seem to depend on the measure of valuation.

Abstractor’s Viewpoint

There have been various debates about the reasons and impact of share repurchases. The authors find strong evidence that capital structure adjustments can enhance firm value for repurchases and the extent of the enhancement depends on the undervaluation of the firm. Market reactions to share repurchases are magnified if the firm is undervalued and underleveraged in relation to the target for the firm. The authors’ results are interesting. Although I do have concerns that the data used in the models are related to just the United States and that buyback schemes may sometimes encourage short termism in investing, this research outlines the conditions for which a share repurchase could be expected to create value. In addition, the authors note that firms tend to recognize the relationship between capital structure adjustments and potential value creation coming from share repurchases.

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