Do firms announce stock repurchases to
signal their quality?
Abstract
In this thesis, I examine the effect of share repurchase announcements on the stock price using a sample of 132 Dutch firms between 2012 and 2017. I find a significant cumulative abnormal return (CAR) of 2,23% for the event window beginning 10 days before the announcement and ending 10 days after the announcement. Some variables linked to the undervaluation hypothesis are able to explain the CAR. All over all, however, I did not find significant prove for the existence of the undervaluation hypothesis in the Netherlands.
Student name: Just van den Hoed Student number: 10549730
Bachelor: Bachelor thesis Economics and Business Specialization: Economics and finance
ECTS: 12
1. Introduction
Whereas dividend payouts dramatically decreased over the past 20 years, share repurchases have become one of the most popular mechanisms for distributing excess cash to shareholders (Fama & French, 2001). In 1999 and 2000 industrial firms in the U.S spent more on share repurchases than on dividends (Grullon & Michaely, 2002). Recently, it has been observed that European countries seem to follow a similar track and increasingly engage in share repurchases. Until the 1980’s share repurchases were forbidden in many European countries, including the Netherlands (Fierkens, 2012). After easing prohibitive restrictions at the end of the 20th century, the activity of share repurchases started to increase in Europe (Grullon & Michaely, 2002). Repurchases also became more common in the Netherlands, after changes in corporate law in 2001 and even more when they were fully legalized in 2006 (Fierkens, 2012). The increase in popularity made it interesting to research the effect of these programs. Vermaelen (1981), Ikenberry et al (2000) and Zhang (2002) show that the announcements of the intention to repurchase shares in the U.S. are followed by positive abnormal returns. Seifert and Stehle (2003), Oswald and Young (2003) and Ginglinger & L’Her (2006) show that this is also the case for several European countries, respectively Germany, the U.K. and France. These findings can be explained by various theories, including the undervaluation hypothesis, agency theory, capital restructuring, dividend substitution, firm performance and management compensation incentives. In this paper the focus will be on the undervaluation or signaling hypothesis. The hypothesis states that firms use share repurchases to signal undervaluation of the stock (Grinblatt et. al, 1984). Nowadays, however, firms are more transparent and asymmetric information between managers and shareholders has decreased (Kelly, 2014). In addition, Skinner (2008) argues that investors should not always consider the announcement as a signal of undervaluation, because share repurchases are more often used as a distributer of excess cash. Therefore, in this research I investigate whether the CAR’s following after share repurchase announcements in the Netherlands can be explained by the undervaluation or signalling hypothesis.
I predict that the share repurchase announcement are still followed by CAR’s, whereas previous research has provided significant prove for the existence of the other aforementioned hypotheses. Bainbridge (2012) argues that the CAR’s during a crises or economic uncertainty are lower because of an increase in corporate governance, which controls over-investment by managers, reducing the need to distribute excess cash. Therefore, I expect that my CAR’s will be higher than the 1.68% Fierkens found in 2012, because my study focuses on a non-crises period. With regard to the existence of the undervaluation hypothesis, I expect my results to be less convincing in comparison to previous research. This, whereas I expect a reduction in asymmetric information over the past years which resulted in a reduced need for the use of share repurchases as a signalling device. To test this prediction, I examine the relation between the CAR’s around share repurchase announcements and factors that are theoretically linked to the signalling of undervaluation. My main research question will therefore be: Are
share repurchase announcements followed by CAR’s in the Netherlands between 2012 and 2017, and can the CAR’s be explained by the existence of the undervaluation hypothesis?
I find that share repurchase announcements in the Netherlands for the event window [-10, 10] between 2012 and 2017 are surrounded by significant CAR’s of 2,23%.
My thesis contributes to prior research, because it focuses on a very recent non-crises period and extensively investigates the effect of firm size on the CAR’s around share repurchase announcements. This is interesting, whereas smaller firms tend to reveal less information to the capital market (Vermaelen, 1981). This results in an increase in asymmetric information between managers and shareholders which is often compensated by other information signalling devices like share repurchases. Karamjeet & Balwinder (2009) and Kelly (2014), however, argue that there is, compared to the 90’s, less asymmetric information between managers and shareholders and an increased transparency in the economic market, which indirectly questions the current existence of the undervaluation or signaling hypothesis.
The rest of my research paper is structured in the following order: In section 2 I discuss the share repurchase history, it’s different methods and motivations. In section 3 and 4 I describe the data sample and the methodology used to obtain my results. Section 5 represents my main findings circumstantiated by some figures and tables. And lastly, in section 6 I formulate the conclusion, discuss limitations on my research and suggest what might be interesting for future research.
2. Literature review
Before starting to perform the empirical analysis it is beneficial to gain a better understanding of share repurchases and their background. Therefore, in this section, I discuss different share repurchase-methods and their motives. In addition, I discuss previous research on this topic.
Share repurchase expenditures heavily increased at the expense of dividends at the end of the 20th century (Grullon & Michaely, 2002). The two main theories that tried to explain this activity are the substitution and the flexibility hypothesis. The substitution hypothesis, which mainly follows the fundamentals of the irrelevance theory by Modigliani and Miller (1961), argues that dividends and share repurchases are perfect substitutes and the choice for the one or the other does not affect firm value. A model designed by John and Williams (1985), however first found that share repurchases can be beneficial considering the taxes on dividend payments. Fama (1991) confirmed this and came up with the market efficiency hypothesis, which states that if markets are not efficient the different pay-out policies may affect firm value with the use of tax tricks.
The flexibility hypothesis, on the other hand, states that share repurchases have increased in prominence compared to dividends because managers prefer the potential flexibility they offer (Brav et al., 2005). Brav et al. (2005) argue that once a firm initiates a dividend payment it is expected to continue making regular payouts, because dividend payments are perceived as a signal of positive future prospects. Share repurchases, on the other hand, are not viewed as being subject to a similar expectation, because they are not necessarily associated with the distribution of excess cash (Dittmar, 2000). Flexibility refers to the firm’s option of distributing cash to its shareholders or keeping it in the firm. By choosing for a share repurchase firms have the option to alter or even suspend an already announced repurchase program. A dividend announcement, in contrast, is barely reversed, since firms are required by law to pay out at least a part of the amount announced (Rama Iyer & Rao, 2017). The inflexibility of dividends mainly caused that U.S. funds which were originally raised for dividend payments, were ‘now’ (the late 90’s) used to repurchase shares (Grullon and Michaely, 2002).
2.1 Share repurchase methods
According to Stonham (2002) popular methods that are in use are tender offers and open market share repurchases. The latter is the most common one, and accounts for approximately 95 percent of all announced share repurchases (Grullon and Michaely, 2002). The other option, tender offers, can be divided into two sub groups: fixed price tender offers and Dutch auction tender offers (Vermaelen, 2005). A not so common method, is the private/ targeted share repurchase (Vermaelen, 2005). First, I discuss the open market share repurchase.
The open market share repurchase is the most common and popular method, because in the case of an open market share repurchase firms are not obliged to actually buy the announced number of shares, in contrast to a fixed price and Dutch auction tender offer (Vermaelen, 2005). It was found that only 80% of the open-market share repurchases is completed in the U.S. (Ikenberry et al., 2000).
Open market share repurchases follow several steps before being completed. In the Netherlands, before firms start to repurchase certain quantities of shares they first have to get approval at the shareholder meeting, which decides on the amount and on the minimum and maximum price of the shares. Then, the shares are often repurchased with the help of a broker, a person that buys and sells goods or assets for someone else (Vermaelen, 1981). During the repurchase the firms pay the same commission rates and prices, like every other investor. In addition, the seller does not know that he is selling his shares to the corporation (Comment & Jarrell, 1991).
Repurchasing in the open market is argued to be the cheapest method (Vermaelen, 2005). In practice, however, it turns out to be quite expensive because of strong regulations on volume and price. In the Netherlands, firms were restricted to repurchase a maximum of 10 percent of their placed capital. In 2007 the government decided to remove this maximum. Large open-market share repurchases, however, may work against the firm as they tend to push up price simply through its own buying (Stonham, 2002). Large share repurchases are therefore done more often via a fixed price or Dutch auction tender offer.
The fixed price tender offer, however, is not so popular anymore and accounts for approximately 2-3 percent of all share repurchases (Grullon & Ikenberry, 2000). According to Stonham (2002), in the case of a fixed price tender offer the company offers its shareholders a specified number of shares for a fixed price. This price is normally set higher than the market price, in order to signal undervaluation (Stonham, 2002). The shareholders have a specific period of time to respond to this offer. If the number of shares offered by the shareholders is smaller than the amount the firm targeted, the firm is committed to buy all shares offered. In
the case of a higher amount offered by the shareholders than the company targeted, it may purchase any amount between the targeted amount and the amount offered (Peyer & Vermaelen, 2005).
Dutch auction tender offers are similar to fixed-price tender offers, as they both specify a number of shares sought (Dittmar, 2000). Instead of a fixed price, however, the Dutch auction does not specify a fixed price, but a range of prices within which each tendering shareholder chooses his or her minimum acceptable selling price (Comment & Jarrell, 1991). This gives the firm a good impression of how its shareholders value their shares (Comment & Jarrell, 1991). The firm than sets a price that makes exactly enough shareholders want to tender (Comment & Jarrell, 1991). The price set is equal to the lowest winning bid and is the same for all shareholders (Comment & Jarrell, 1991). If a shareholder’s bid was higher than the price set his shares will be tendered for the price set and if, on the other hand, a shareholder’s bid was lower than the price set his shares will not be tendered (Comment & Jarrell, 1991).
Dutch auction tender offers often tend to generate extremely high abnormal returns during the announcement-period (Comment & Jarrell, 1991). Sometimes even between three or four times bigger than in the case of an open market share repurchase (Dittmar, 2000). Tender offers are seen as a stronger signal of manager’s inside information of undervaluation as they are offered at a substantial premium, which provokes a higher positive abnormal return (Stonham, 2002). Comment & Jarrel (1991) argue that Dutch auction offers are weaker signals of undervaluation than fixed price tender offers, because the minimum of a Dutch-auction offer’s price range defines the maximum amount of dividend that non-tendering shareholders might miss out on, whereas this will be the share price in the case that the repurchase is not understood as a signal. So, a Dutch-auction tender offer with a low minimum should not be as convincing as a signal of undervaluation, because the purchase premiums in fixed-price tender offers are significantly higher.
Next, I want to discuss the private or targeted share repurchase, where the firm approaches a large shareholder to repurchase its shares from (Peyer & Vermaelen, 2005). Privately negotiated repurchases are often used as greenmail, better known as defensive measures to fight takeovers (Peyer & Vermaelen, 2005). However, it may also be the case that shareholders take the initiative to sell their shares and approach the firm. They might prefer to sell their shares to the company instead of in the open market, because it could be that the shares are thinly traded (Peyer & Vermaelen, 2005).
Private or targeted share repurchases are also often followed by positive abnormal returns, whereas they are offered at a substantial premium above the market price (Peyer & Vermaelen, 2005). If a firm considers its share price to be undervalued it can be beneficial to rebuy a specific amount of shares from one shareholder at a premium price. This price, however is often still lower than the price the firm believes its stock is worth, otherwise the firm would make a loss. Whereas the seller is fully aware that he is in negotiation with a completely informed company he might be mistrustful, which makes it more difficult for the firm to gain advantage from undervaluation information. Only if the firm repurchases at a discount compared to the market price (Peyer & Vermaelen, 2005), the repurchase can be seen as a positive signal, whereas the firm itself incurs a loss by repurchasing below the market price. The undervaluation hypothesis, however, will be outlined more extensively in the part on share repurchase motives.
2.2 Share repurchase motives
In Europe, share repurchases were legalized in the late 90’s due to an increase in popularity in the United States (Grullon & Michaely, 2002). Many research has been done on the positive abnormal returns that were followed by the announcement of share repurchases since. In the remainder of this paragraph different hypothesis trying to explain the motives for share repurchases and the existence of the abnormal returns will be discussed. In 2000, Dittmar came up with five main hypotheses which are all taken into consideration. It may also be, and is actually more realistic, that a mix of different hypothesis would be the best explanation for why firms repurchase. Whereas this paper focusses on the undervaluation hypothesis, because its current existence is questioned (Kelly, 2014), this theory is being explained more extensively. First, I discuss the free cash flow hypothesis by Jensen (1986).
One of the reasons firms repurchase stock is to regulate the free-cash flow. Free-cash flow is cash flow in excess to that required to fund all positive net present value projects discounted at the cost of capital (Jensen, 1986). Managers are often tempted to use free-cash flow for empire building, instead of creating shareholder value (Jensen, 1986). Therefore, many companies try to restrict the excess capital and prevent managers from over-investing by using the excess capital to repurchase shares. Harford et al (2008) found that higher shareholders influence is associated with lower cash holdings. The problem, however, is the tradeoff between supplying enough cash for the managers to fund all positive projects and not providing excess internal capital which allows the manager to invest in empire building.
Distributing excess cash can also be done by paying dividends. Repurchasing shares, however, has as argued by Brav et al. (2005) the flexibility advantage over paying dividends. In addition, firms are often expected to pay dividends on a regular basis, whereas share repurchases can be done on a more unregularly basis.
Another advantage in favor of share repurchases is explained by the optimal leverage ratio hypothesis. The optimal leverage ratio hypothesis is based on the fact that share repurchases can affect the debt-to-equity ratio, because the quantity of outstanding equity can be influenced by repurchasing shares. In addition, the opportunity to repurchase shares with debt could also lead to an increase in debt-to-equity ratio, whereas an increase in debt results in an increase in debt-to-equity ratio. Since interest paid on debt is tax deductible, shareholders could gain a profit in the case of a higher share price (Vermaelen, 1981).
Bagwell and Hoven (1988) first argued that an optimal leverage ratio exists, although Modigliani & Miller have always claimed it was impossible. In the Netherlands, it is possible to deduct interests from the fiscal profit (Fierkens, 2012), which implies that debt is less expensive than equity. Before 2001 Dutch companies were prohibited by law to repurchase shares, but, nowadays, within restrictions, share repurchases are indeed sometimes used to increase the debt-to-equity ratio and thereby possibly transfer money from bondholders to shareholders (Fierkens, 2012).
The management incentives hypothesis argues that the transfer of money from bondholders to shareholder might also be attractive for managers, whereas managers are often rewarded in the form of stock options (Emmerich, 2005). This makes it attractive to use share repurchases to distribute cash, because share repurchases do not result in a decrease in the per-share value (Brav et al., 2005). In addition, less shares outstanding means an increase in payment per share, whereas there are less investors the profit has to be shared with. An increase in earnings per share leads to an increase in share price, and therefore in an increase of the value of the option the manager holds. Dunsby (1995) first proved repurchases to be more attractive for bond awarding companies instead of paying dividends.
A not always applicable explanation is the takeover deterrence hypothesis. Takeovers that are not always preferred by both parties are called hostile takeovers. The takeover deterrence hypothesis argues that share repurchases are used as a defense mechanism. Bagwell (1991) first showed that the acquisition can be made more expensive for the acquirer with the help of a Dutch-auction share repurchase. This, to only repurchase the shares of the shareholders with the lowest reservations, which increases the lowest stock price for which the stock is available and only leaves a pool with shareholders that highly value their shares.
High valuations result in an expensive takeover, which makes it less attractive for the acquirer.
Finally, the most popular explanation for the positive abnormal returns after share repurchase announcements and the main focus of this paper is the undervaluation or signaling hypothesis (Vermaelen, 1981). Share repurchases offer flexibility not only in the choice to distribute excess funds but also when to distribute these funds. This flexibility in timing is beneficial because firms can wait to repurchase until the stock price is undervalued (Dittmar, 2000). Vermaelen (1981) argued that when firms repurchase their stock they try to give an information signal to its investors. In the case that the company offers to buy its shares at a substantial premium the hypothesis argues that the firm tries to signal undervaluation of its stock. The positive stock price reaction after the share repurchase announcement should correct for the undervaluation of the stock (Dann, 1981).
The signaling of undervaluation of stock is as described in the repurchase methods section mostly done via a tender offer, whereas these often exceed the market price. A later study of Chan, Ikenberry and Lee (2004) showed that relatively smaller firms mostly repurchase shares via tender offers, which supports the statement made by Ikenberry et al. (1995) that smaller firms tend to use share repurchases as a signalling device for undervaluation more often. For open market share repurchases, on the other hand, Vermaelens (1981) results were less conclusive, because open-market share repurchases are often used by managers in order to push up the share price instead of signaling undervaluation (Fried, 2001). This is possible, because open market share repurchases can be costless, in the case of making the announcement, but not actually repurchase. The market will not react on just a common announcement without valid argumentation, because of the insecurity shareholders have about the creditworthiness of the announcement. Only if the costs of the announcement are high enough, the market is able to recognize and anticipate if necessary, which results in a positive reaction on the announcement made by the management (Stephens & Weisbach, 1998).
Vermaelen (1981) showed that the height of the abnormal return and the extent of undervaluation also depends on the firms book-to-market ratio, which is a ratio used to find the realistic value of a company by comparing its book value to its market value. Its book value is calculated by looking at the firm's historical cost, also named accounting value, and his market value is determined in the stock market through its market capitalization. Hackethal & Zdantchouk (2006) found that firms with high book-to-market value ratios are more likely to do a repurchase with underpricing as an incentive.
3. Hypotheses
As stated in the introduction, Fierkens (2012) found a CAR of 1,68% in the Netherlands during the crises. Whereas, Bainbridge (2012) proved that the CAR’s are lower during a crises or economic uncertainty, because of an increase in corporate governance, I expect my CAR’s to be at least as high, since my research focusses on a non-crises period. This, in combination with the related literature lead to the following hypothesis:
H1: Share repurchase announcements in the Netherlands between 2012-2017 are followed by
positive CAR’s.
Ikenberry, Lakonishok & Vermaelen (1995) show that the abnormal returns only correct the undervaluation of the stock to a certain extent. They showed that more variables significantly affect the abnormal returns and first found a relation between firm size and the CAR’s around the announcements. Smaller firms tend to reveal less information to the capital market (Ikenberry et al., 1995). According to Vermaelen (1981) this is mainly because of less coverage in the financial media, less attention by financial analysts and lower institutional ownership, which results in reduced market transparency towards its shareholders, that is often compensated by other signalling devices. Therefore, share repurchases made by smaller firms have an increased likelihood to signal undervaluation. Relatively larger firms, in contrast, have lower levels of information asymmetry and therefore reduced need to signal undervaluation with the help of share repurchases. Kelly (2014), however, argues that there is, compared to the 90’s, increased market transparency towards shareholders, which should result in reduced need to use share repurchases as a signaling device. Taken all this information into consideration lead to my second hypothesis:
H2: The signalling hypothesis exists in the Netherlands and is more promising for relatively
4. Methodology’s
4.1 The event study
To investigate whether share repurchase announcements affect the stock returns an event study is performed using the program Event study on Wharton research data services. The first event study ever was conducted by Mackinlay (1997), and his main guidelines are also used in this research. First, the event of interest needs to be determined, which is the announcement date in this case. Secondly, the period over which the stock prices are going to be examined needs to be determined. In this research 5 different event windows are being accessed, [-10, 10], [-5, 5], [-3,3], [-1, 1] and [0, 5], with zero as the announcement day. To determine whether abnormal stock returns occur Wharton first calculated the normal/ expected return with the help of a so called estimation window, a time frame before the event window in which no unordinary events take place so a good prediction can be made (Mackinlay,1997).
Figure 1. Timeline of an event study
The estimation window used is as Mackinlay recommends [-115, -15]. The normal returns are being predicted according to the market model, whereas the market model is an one-factor model, which is preferred by an event study. This, whereas the explanatory power of adding extra factors is limited. “The reason for the limited gains is the empirical fact that the
marginal explanatory power of additional factors to the market factor is small, and hence there is little reduction in the variance of the abnormal return (Mackinlay,1997)”. The
market model follows the following formula to calculate these returns:
𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑅𝑚𝑡 + 𝜀𝑖𝑡 (1)
Then, Wharton runs the market model and calculates the abnormal returns per day and the cumulative abnormal return per event window.
Where 𝐴𝑅𝑖𝑡 is the abnormal return of stock i at time t, 𝑅𝑖𝑡 the actual return of stock i at time t and 𝐸(𝑅𝑖𝑡) is the expected return of stock i at time t. Taking the sum of all abnormal returns results in the following definition of the CAR for the event window (-10,10):
𝐶𝐴𝑅𝑖(𝜏1, 𝜏2) = ∑𝜏2 𝐴𝑅𝑖𝑡
𝑡=𝜏1 (3)
To test whether the CAR’s are significantly different from zero I first add all CAR’s of every firm together in order to calculate the cumulative average abnormal return (CAAR).
𝐶𝐴𝐴𝑅(𝜏1, 𝜏2) =𝑁1∑𝑁 𝐶𝐴𝑅𝑖(𝜏1, 𝜏2)
𝑖=1 (4)
These CAAR is then tested using a two sided t-test with the test-statistic:
𝑡 = 𝐶𝐴𝐴𝑅(𝜏1,𝜏2)
√𝑣𝑎𝑟(𝐶𝐴𝐴𝑅(𝜏1,𝜏2)) ~ N (0, 1) (5)
The main findings of the event studies can be found in the section results.
4.2 The regression analysis
After calculating the CAR, I estimate the following model:
𝐶𝐴𝑅10 = 𝛼𝑖 + 𝛽1𝐶𝐴𝑆𝐻 + 𝛽2𝑀𝐵+ 𝛽3𝑅𝑂𝐴 + 𝛽4𝑇𝐸𝑁𝐷𝐸𝑅 + 𝛽5𝐿𝑂𝑊 + 𝛽6𝑀𝐸𝐷𝐿𝑂𝑊 +
𝛽7𝑀𝐸𝐷𝐻𝐼𝐺𝐻 + 𝛽8𝐻𝐼𝐺𝐻 + 𝜀𝑖 (6)
Where:
CAR10 = The cumulative abnormal return for the event window [-10,10], calculated with the help of Wharton.
CASH = The amount of cash holdings on the announcement day.
B/M = The ratio between the book value and the market value of the firm on the announcement day.
ROA = The return on assets is defined as net income plus interest, minus interest savings, divided by average total assets as reported in the last financial statement prior to the announcement day.
TENDER = A dummy variable which equals 1 if the repurchase method is a tender offer and zero otherwise.
LOW = A dummy variable which equals 1 if the announcing firm has a market value between 0-5000 on the announcement day and zero otherwise.
MEDLOW = A dummy variable which equals 1 if the announcing firm has a market value
between 5000-10000 on the announcement day and zero otherwise.
MEDHIGH = A dummy variable which equals 1 if the announcing firm has a market value
between 10000-15000 on the announcement day and zero otherwise.
HIGH = A dummy variable which equals 1 if the announcing firm has a market value
larger than 15000 on the announcement day and zero otherwise.
The CAR of the [-10, 10] event window is used as the dependent variable, because this was the only event window with a CAAR significantly different from zero. According to Mackinlay the event window of [-1, 1] should be used as the main event window. In this research, however, the event window [-1, 1] results in a CAAR of approximately zero. Therefore, the regression on this CAR leaded to highly insignificant coefficients for the explanatory variables.
I include CASH to correct for the free cash flow hypothesis, whereas Grullon & Michael, (2004) show that high cash holdings increase the temptation for managers to over invest. To reduce these high cash holdings shareholders might therefore decide to repurchase shares which reduces the manager’s opportunity to over invest in order to build an empire. These share repurchases are expected to be followed by CAR’s, whereas the risk of over-investment is reduced (Grullon & Michael, 2004).
I include B/M, because Vermaelen (1981) shows that correcting for this ratio significantly affects the CAR. The B/M is a ratio used to find the realistic value of a company by comparing its book value to its market value. Hackethal & Zdantchouk (2006) found that firms with high market to book ratios are more likely to do a repurchase with underpricing as an incentive. Which is a realistic finding, whereas firms with high book values and low market values are undervalued (Dittmar, 2000). Thus, repurchases done by firms with high
I include ROA as a proxy for profitability, because Grullon (2002) argues that more profitable companies are expected to have larger investment opportunities than less profitable firms. If the firm then decides to use his profit to repurchase shares it is considered as a signal of strength, because the company shows that it has the possibility to reduce financial flexibility and disposable resources without negative consequences (Fierkens, 2012). Moreover, the company shows the market that it is not overinvesting. Therefore, I expect firms with high ROA’s to be followed by high CAR’s.
I include TENDER, because as described in the undervaluation hypothesis part, tender offers are deals were a specific amount of shares is repurchased for a specific price. This specific price is often set above the market price in order to signal undervaluation. Therefore, it is expected that tender offers result in a significantly higher positive abnormal return
I include four dummies: LOW, MEDLOW, MEDHIGH and HIGH, which represent a proxy for the explanatory factor firm size. Whereas the firms market value and the B/M have a linear relationship I decided to use dummy variables to divide the firm’s market values into four categories. This, because, I do not expect a linear relationship between the uniform firm’s market value and the CAR. These dummies are included, because smaller firms tend to reveal less information to the capital market. This results in an increase in asymmetric information between managers and shareholders. To compensate this reduced market transparency, managers of smaller firms tend to use share repurchases as a signalling device for undervaluation more often. Therefore, I expect that share repurchase made by firms with lower market values are followed by higher CAR’s. During the regression one of the four categories is being omitted as a reference variable in order to prevent a dummy trap.
5. Data and descriptive statistics
The share repurchase announcements are from Zephyr. Zephyr mainly contains information on mergers & acquisitions, IPO’s, venture capital and many other deals. For this research only share repurchases between the period of the 1st of January 2012 until the 31st of 2017 made by firms listed on the AEX were taken into consideration. This period is taken with the intention to access a non-crisis period with a stable economy. Announcements that were made by firms that were no longer listed on the AEX and announcements with a non-Dutch target ISIN number are eliminated, because I specifically focus on the Dutch market. Furthermore, the event of rumours about an announcement were excluded, because they could not be linked to a single date, which resulted in a final sample of 132 share repurchase announcements.
To calculate the abnormal returns, the stock and historical data needed are gathered by the program Wharton itself. I then collect other firm-specific data from Datastream. For the regression the following data are obtained on the specific share repurchase announcement dates by using the firms ISIN numbers: The return on assets (ROA), the amount of cash (CASH), the book-to-market (B/M) the method of repurchasing and the firms market value (MV). The MV is used to measure firm size, this, instead of the firm’s market capitalization whereas Datastream does not contain many market capitalizations. Unfortunately, not all share repurchase announcements can be taken into consideration, whereas Datastream did not contain all necessary data for every announcement. Which resulted in a final sample of only 40 firms for the regression analysis. Their descriptive statistics can be found in table 1.
Table 1. Descriptive statistics for the regression (N=40)
Dependent variable
Independent variables
CAR10 CASH B/M ROA TENDER MV
Minimum -0.06 12244.000 0.40 -0.04 0 167.38 Maximum 0.22 12400000 12.1 0.52 1.0 40679 Mean 0.02 2660528.0 3.07 0.08 0.6 11950 Standard deviation 0.05 4013359.0 3.20 0.04 0.5 10758
Table 2. Spearmen rank correlations between the independent variables
CASH M/B ROA MV TENDER
CASH 1.0000
M/B -0.4128* 1.0000
ROA -0.2539 0.4160* 1.0000
MV 0.4819* 0.1001 0.1627 1.0000
TENDER 0.1515 -0.0709 0.0739 0.1408 1.0000
Note: *, **, *** significantly different from zero at the 10%, 5% or 1% interval respectively
As can be seen in table 2 several variables are significantly correlated with each other, which may result in multicollinearity and can lead to insignificant coefficients for the regression.
6. Results
6.1 The event study
In this section I will briefly discuss and summarize my main findings on the even study. Table 3 presents the significance tests of the CAR for five different event windows. Only for the event window [-10, 10] a significant CAR of 2,23% was measured. Beforehand, it was expected that more event windows would show significant CAR’s. The graphs for the event windows [-5, 5], [-3, 3] and [-1, 1] however, clearly showed negative CAR’s before the announcement date and positives after the announcement date, which resulted in a CAR of approximately zero. This phenomenon strongly points in the direction of the undervaluation hypothesis, which states that the announcements signal undervaluation and will results in an increase in stock price. Although it is shown in table 3 that the CAAR for the event window [0, 5] was, compared to the previous mentioned three event windows, a bit higher, it still not significantly differs from zero. This might be explained due to the fact that firms are becoming more transparent and do not need share repurchases as a signalling device anymore.
Table 3. CAAR’s tested for different event windows
Event window t-test p-value
[-10, 10] 2.77*** 0.009***
[-5, 5] 0.63 0.530
[-3, 3] 0.09 0.930
[-1, 1] 0.67 0.504
[0, 5] 0.88 0.387
Note: *, **, *** significantly different from zero at the 10%, 5% or 1% interval respectively
Only for the event window [-10, 10] a significant CAR of 2,23% is measured. Figure 2 shows that the CAR’s increase even more after the announcement date, which again supports the undervaluation hypothesis for the before mentioned reasons.
6.2 The regression analysis
In this section I will briefly discuss and summarize my main findings on the regression analysis. In table 4 the coefficients found for the explanatory variables are shown and indicated whether they are significantly different from zero.
Table 4. The regression results
Note: p-values are reported in parenthesis
Note: *, **, *** significantly different from zero at the 10%, 5% or 1% interval respectively Note: _CONS is a constant which represents the expected mean value of CAR10 if all X=0 Note: R2 is not a coefficient, but reflects the percentage of the variances of CAR10 that is explained by the variances of the explanatory variables
The coefficient for the dummy TENDER is significantly different from zero at a 5% interval and is as expected positive. This provides evidence for the undervaluation hypothesis, whereas tender offers are often offered at a price above its market price. This finding also confirms Vermaelen’s (1981) statement that tender offers in specific are often used to signal undervaluation. Variable Coefficient CASH -0.00000 (-0.73) B/M -0.00465 (-1.40) ROA 0.00205 (1.41) TENDER 0.03550 (2.08)** LOW 0.02475 (1.17) MEDLOW -0.02458 (-1.06) MEDHIGH -0.01348 (-0.49) HIGH -0.02575 (-1.32) _CONS 0.04007 (2.56)** R2 0.28980
The coefficient for the variable LOW is as expected to be positive, which means that firms with a market value between 0-5000 show significantly higher CAR’s, which is in line with the expectation that small firms use repurchases as a signaling device more often than large firms do. The three other categories MEDLOW, MEDHIGH and HIGH show negative coefficients, which might indicate that firms with a market value higher than 5000 do not use share repurchase announcements to signal undervaluation. These coefficients however, are in line with previous research (Ikenberry et al., 1995 and Stephens & Weisbach, 1998) not significantly different from zero and therefore not provide significant evidence for my second hypothesis that the signalling hypothesis is more promising for relatively small firms.
As can be seen in table 4 the coefficients for CASH, B/M and ROA are approximately zero. The result for CASH would question the free-cash hypothesis and is not in line with my expectations. The results for B/M and ROA, on the other hand question my second hypothesis on the undervaluation hypothesis again. The most reasonable explanation would be that the final sample, which only consists of 40 repurchases is not large enough to provide reliable results, or the existence of multicollinearity between the variables. Therefore, I decided to reflect the robustness of the regression model.
6.3 Robustness
Whereas I did not find significant results for the coefficient of CASH, B/M and ROA I decided to assess the robustness of my model. The insignificance of these coefficients can be caused by several factors. I examine the sample size, multicollinearity and the goodness of fit. The sample size is relative to research done in other countries small. This, whereas the Netherlands is a relatively small country which only announced 132 share repurchase announcement between 2012-2017. In addition, for the regression Datastream only contained the necessary data for 40 firms, which might cause the insignificant coefficients, whereas it does not provide a realistic picture.
Another factor that may affect the insignificant results could be the multicollinearity, which might exist in my model as can been seen in table 2. Several variables are significantly correlated with each other which can be considered as an evidence for multicollinearity and the cause for the insignificant coefficients for CASH, B/M and ROA. Therefore, further research should decide on which variables to eliminate.
Lastly, I examine the goodness of fit of my model. My model finds a R2 of 0.28980, which indicates that 28,980% of the variances of CAR10 is explained by the variances of the explanatory variables. This means that not all variables affecting the variances of the CAR10 are included, whereas almost 70% of them remains unexplained by my model. This might result in omitted variable bias and endogeneity of the model, which explains the insignificant results of the coefficients CASH, B/M and ROA.
Conclusion
This is an empirical study on the effect that share repurchase announcements have on the stock prices and to what extent the differences in CAR’s followed by these announcements can be explained by the undervaluation hypothesis and firm size. It can be concluded that share repurchases in the Netherlands over the period between 2012 and 2017 are not significantly followed by CAR’s, except for the event window [-10, 10]. It has been found that the insignificance is mainly caused by the fact that the CAR is negative before the announcement date and positive after the announcement date, which results in a CAAR of approximately zero. This fact, however, does provide evidence for the undervaluation hypothesis, whereas this hypothesis states that share repurchase are used as a signaling device for undervaluation, and are therefore followed by positive CAR’s.
Unfortunately, the regression analysis did not provide significant evidence for the existence of the undervaluation hypothesis in the Netherlands. This might partly be caused by the existence of multicollinearity. For further research it would therefore be interesting to investigate whether variables like TENDER and firm size have different effects on the CAR if they are merged. This, whereas small firms predominantly tend to repurchase their shares via tender offers (Vermaelen, 1981). The dummy variables used to separate the firms based on their market values might then show more effect. Furthermore, further research should also include more explanatory variables, whereas in this research omitted variable bias occurred. In addition, the final sample for the regression only consisted of 40 firms, which might be the cause of insignificant outcomes. For further research I would therefore highly recommend to use a larger sample. For the Netherlands and this time period, however, this was the largest sample possible, which makes it difficult to do research in this field in small countries.
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