Stock Repurchases and the EPS Enhancement Fallacy

A common belief among practitioners and academics is that the increased EPS associated with a stock repurchase creates value for a firm’s shareholders. This belief is flawed. With the use of a numerical example and an analysis of ExxonMobil’s recent stock repurchases, this article demonstrates the magnitude of the distortion that arises from using EPS to make such repurchase decisions. The effect of share repurchase is also compared with the effects of alternatives—payment of dividends and cash accumulation. Relative to cash accumulation, neither the negative effect of dividends nor the positive effect of repurchases on EPS is associated with changes in the wealth of shareholders at time zero. Record numbers of firms have carried out share repurchases in the past several years. Recently, firms as diverse as 3M, Capital One Financial, Caterpillar, CBS Corporation, and Accenture announced repurchases of more than $1 billion each. A commonly cited reason in firm press releases and executive surveys for the increased use of share repurchases is to increase EPS. This article addresses the effect of stock buybacks on both a firm’s earnings per share and the value of an investor’s holdings. We demonstrate an important but generally ignored effect of increasing a firm’s EPS growth through share repurchase: Although buying back shares increases EPS, it leaves the value of an investor’s holdings unchanged. Furthermore, we demonstrate that the EPS increase associated with a buyback is merely a risk–return trade-off. The reason is that in a repurchase, the firm retires safe cash and, as a result, its assets become riskier than before the repurchase. With the increased risk, the expected return increases, and this effect is what is reflected in the higher expected EPS.Firms generally choose among several alternatives for using their excess cash. Options typically include dividend payment, share repurchase, and cash accumulation (no payout). We consider each of these alternatives. We show that the value of an investor’s holdings is invariant with respect to the choice of payout policy but that each alternative provides a unique risk–return trade-off that is reflected in the EPS path over time. These results conflict with the commonly accepted intuition that increasing EPS through repurchase creates economic value for the investor.Miller and Modigliani (MM) demonstrated that in a perfect world, payout policy does not matter. The literature that followed their seminal work focused on explaining how market imperfections, however, make payout policy relevant. A broad range of reasons have been given for a firm’s repurchases. They include signaling of undervalued equity in conditions of information asymmetry, reducing the agency costs of having free cash, substituting repurchases for dividends to lower taxes, and capital structure adjustments. We abstract from these motivations and focus on EPS growth. Although MM is well known, managers continue to use EPS as a significant input into their repurchase decision. We show, however, that even in a perfect world, payout policy affects the EPS path but that this result should not be confused with the creation or destruction of value for shareholders. Our analysis thus demonstrates the magnitude of the distortion from using EPS to make share repurchase decisions. At the same time, it guides financial analysts in how to interpret EPS changes—namely, to distinguish between EPS changes that are associated with changes in expected shareholder wealth from EPS changes that are not.As an application, we consider the effect that alternative payout policies would have had on ExxonMobil’s EPS in the 2002–06 period. In this period, ExxonMobil made sizable share repurchases and large dividend payments. We compare the results of our hypothetical policies with ExxonMobil’s actual payout policy. We show that more than 16 percent of the firm’s EPS growth over the past four years is an artificial result of its repurchase program and cannot be associated with improvement in operating performance.Our results have important implications beyond the effect of share repurchase on EPS. For example, many managers suggest that their firm repurchase shares to reverse the share dilution of employee stock and option compensation. Our results suggest that, although repurchasing shares prevents dilution of EPS, it does not prevent dilution of value to shareholders. The reason is that the granting of stock and option compensation does dilute value, but repurchases do not enhance value. Similarly, the newly popular practice of “accelerated repurchase” does not enhance value. In an accelerated repurchase, the firm borrows a large quantity of shares from its shareholders through an investment banker and retires those shares upon receipt. Then, over time, the investment banker buys shares in the open market on behalf of the firm and returns them to the lending shareholders. The practice enables a firm to quickly increase EPS while repurchasing shares slowly over time. The results in this article imply that boosting EPS in this manner does not create value for shareholders.