Stock buybacks do not necessarily help just the CEOs whose compensation is tied to their companies’ earnings per share, but can also advance the interests of shareholders, according to a new study.

Steven Young

New research in the American Accounting Association’s journal Accounting Review found that stock buybacks are not always just a way to inflate executive pay or pump up the EPS at companies. A 117 percent upsurge in stock buybacks last year by S&P500 companies has set off an upsurge in warnings about the nefarious ways executives use such repurchases to enrich themselves at the expense of shareholders.

Repurchases may provide a payout to investors, but they can also be a way to mask business slowdowns and to artificially inflate earnings per share by the trick of simply reducing the number of shares outstanding. Particularly suspect in skeptics' eyes are repurchases engineered by executives whose pay is linked to meeting performance targets based on a company's earnings per share.

A study by Steven Young of Lancaster University Management School and Jing Yang of Towers Perrin, published in Accounting Review, found that even in companies with EPS-contingent pay, stock buybacks on the whole do not subvert the interest of shareholders and even have the net effect of modestly advancing them. Stock repurchases do find special favor in such companies, the study confirmed, but the study also found that "the predicted odds of a repurchase for firms for which executive compensation depends on EPS performance are almost twice the level observed for firms for which rewards are independent of EPS."

"On balance our evidence suggests that EPS-driven repurchases yield net benefits to shareholders... and we find no evidence that EPS-driven repurchase payouts occur at the expense of either investment myopia or dividend substitution," the study noted. "Repurchase incentives created by EPS-contingent pay help align managers' interests with those of shareholders."

Young conceded that the findings came as something of a surprise. "We undertook the research expecting to find executives lining their own pockets and shareholders losing out,” he said. “But early on an economist colleague commented that, if the matter were that simple, companies would probably have abandoned EPS-contingent pay by now, and, since it was still very much a fact of corporate life, shareholders were probably realizing benefits from it. Our findings suggest my colleague had a point."

"In general, executive-pay schemes represent ways of addressing what scholars call the agency problem—that is, how to motivate executives to act not just in their own self-interest but in the interest of the shareholders," Young added. "Unfortunately, there's no perfect way to do this, and, while the amount of earnings per share is scarcely the best predictor of strong long-term company performance, it's an important number to the markets, so that, even if executives act opportunistically, the shareholders can still benefit. In short, among a bunch of imperfect pay options, motivating management to repurchase shares may be the least imperfect, problematic though buybacks sometimes can be. This doesn't mean that shareholders should let their guard down. Here as elsewhere they need to be vigilant, scrutinizing repurchases especially closely in any case where executive compensation is tied to per-share metrics."

The study's findings derive from a comparison of performance between firms that carried out stock repurchases once or more during the nine-year period of 1998-2006 and a group of matched controls that were non-repurchasers. In all, the repurchasing firms accounted for 665 buybacks.

Buybacks were twice as likely to occur in companies with EPS-contingent compensation as they were in control companies, the study found. But no evidence emerged that the combination of buybacks with EPS-contingent pay resulted in inferior company returns on assets or stock performance in either the year or the two years following repurchases. In fact, that combination was associated with increased returns on assets in the post-buyback year in firms with below-average cash resources, a finding that casts doubt on the claim of buyback skeptics that repurchases divert funds from profitable investment opportunities. In addition, buybacks do not appear to substitute for or diminish payment of dividends.

"Findings suggest that dividends and repurchases represent complementary payout options that in conjunction yield higher payouts to shareholders regardless of whether repurchases are driven by EPS-contingent compensation arrangements," said the study.

In addition, the study found that EPS-contingent pay arrangements increase the likelihood of buybacks in situations where they are widely seen as useful—in companies with surplus cash and in firms with undervalued stock.

"Our findings reveal significant contracting benefits from the repurchase incentives that result from linking executive compensation to EPS," the study concluded. Those benefits suggest "why EPS-based targets remain a popular choice in executive compensation contracts despite their obvious limitations."