Corporate payouts have reached record levels. Over the past half-century, publicly-held U.S. firms have more than tripled inflation-adjusted dividends, while real share repurchase values have ballooned from $5 billion in 1971 to almost $1 trillion in 2018 and become the dominant form of payout. Given the magnitude of these distributions, it is not surprising that they have garnered the attention of researchers and the skepticism of politicians, who have suggested that buybacks are used in ways that are contrary to the health of the economy and workers. In fact, Democrats recently proposed a 1 percent excise tax on stock buybacks and a three-year ban on insider stock sales following buybacks. Consequently, understanding their causes and consequences is more important than ever.
We survey the literature with a particular emphasis on research undertaken in the last decade. Previous surveys conclude that payout policy is driven mostly by undervaluation and by firms’ desire to mitigate overinvestment caused by Jensen’s (1986) free cash flow problem (Allen and Michaely, 2003; Vermalen, 2005; Farre-Mensa et al., 2014). We show that while traditional explanations of payout policy such as dividend substitution, agency costs, signaling, and taxes generally continue to have some support, these motives are complex and new motives have emerged as well. New research shows that firms do not directly substitute repurchases for dividends; often these payouts complement one another. Firms use cash that would have been used to increase or initiate dividends to instead increase or initiate repurchases (Grullon and Michaely, 2002; Banyi and Kahle, 2014). In fact, it is repurchases’ distinctions from dividends – namely, their perceived flexibility relative to sticky dividends – that has likely made them so popular. Indeed, during recessions and in response to credit supply shocks, firms pull back on repurchases more so than on dividends (Dittmar and Dittmar, 2008; Bliss, Cheng, and Denis, 2015; Floyd, Li, and Skinner, 2015). The paradox of repurchase flexibility is that it led more firms to repurchase regularly; in the process investors have come to expect them.
Recent work reexamines if repurchases are driven by agency costs associated with excess cash flow. Firms with greater agency costs of free cash flow (John, Knyazeva, and Knyazeva (2011)) or better governance (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000; Alzahrani and Lasfer, 2012)) make larger payouts. However, if reducing agency costs were the primary motive for repurchases, then repurchases would not have causal effects on investment and would not require debt financing, as other research shows (Almeida, Fos, and Kronlund, 2016; Farre-Mensa, Michaely, and Schmalz, 2021). Additionally, managerial incentives like executive compensation or attaining earnings per share goals drive some repurchases (Cheng, Harford, and Zhang, 2015). While agency-related, these types of repurchases do not solve agency problems of free cash flow but are a symptom of it.
Recent evidence also suggests that repurchases may no longer signal undervaluation to the same extent as before. Although stock prices jump on average when a firm announces a repurchase, they no longer consistently continue to rise in the long-term (Obernberger, 2014; Fu and Huang, 2016; Lee, Park, and Pearson, 2020). Further, the largest and most profitable firms, which have the least need to signal information to investors since information asymmetry between managers and investors is low, repurchase the most and do not advantageously time repurchases. Skilled repurchase timing is concentrated within certain subsets of firms: less frequent repurchasers, small firms, high growth firms, and firms with more liquid stock and lower institutional ownership (De Cesari, Espenlaub, Khurshed, and Simkovic, 2012; Ben-Rephael, Oded, and Wohl, 2014; Dittmar and Field, 2015). These findings are inconsistent with the notion that companies repurchase shares primarily to send a signal..
New research teaches us that both investor and corporate tax rates may affect payout policy more than we thought. The tax preferences of institutional shareholders affect payouts and payout influences which investors are drawn to the firm (Desai and Jin, 2011). Further, reductions in corporate tax rates, specifically taxes on repatriated income, lead to significantly higher repurchase levels (Kahle and Stulz, 2021; Faulkender and Petersen, 2012).
Finally, in addition to examining what motivates payout, recent research studies how payout policy and other firm characteristics and policies are interrelated. For example, repurchases tend to improve the liquidity of the firm’s stock and affect firm risk (Hillert, Maug, and Obernberger, 2016). Payout policy is also associated with investment policy and hedging policy (Bonaime, Hankins, and Harford, 2016), and even relates to strategic decisions about product-market competition and labor contracts (Hoberg, Phillips, and Prabhala, 2014; Hwang and Kahle, 2022).
While the payout policy literature, and the repurchase literature in particular, are growing and maturing, many interesting research questions are still open for debate. For example, what are the effects of government policies such as taxation, enhanced disclosure, or trading restrictions on repurchases and, in turn, on other important firm decisions such as investment and R&D? Importantly, what changes in regulation are necessary?
An underlying assumption in the political debate is often that repurchases are an effective tool to manipulate stock prices and that managers employ repurchases for personal benefit. However, given the importance to both policymakers and academic researchers of understanding these issues, we know surprisingly little about the extent to which firms manipulate prices through repurchases and managers abuse these transactions. One notable exception is a study by Bargeron and Farrell (2021), who show that the average repurchase increases stock prices by only about half a percentage point, and this effect reverses the following month. Despite this recent progress, more research in this important area is warranted.
At present, the SEC has proposed amendments to Rule 10b5-1 plans that would limit multiple/overlapping plans, enhance “good faith” requirements, and modernize and improve repurchase disclosure, including requiring daily disclosure on a new Form SR and requiring additional detail on a company’s share repurchases. The intent of such amendments is to improve the quality and timeliness of share repurchase disclosures, thereby reducing information asymmetries between firm insiders and investors and reducing “potential harms” associated with these transactions. Such changes to disclosure could create additional avenues for research on repurchases.
In addition, the endogeneity of corporate payout decisions remains a hurdle for researchers. An example of such a challenge is disentangling whether firms decrease investments to repurchase stock or rather repurchase stock because of a dearth of good investments. These types of questions are empirically challenging but of utmost importance to policymakers contemplating how to regulate buybacks. To answer such questions, innovations in econometric techniques combined with regulatory shocks within the United States and abroad will certainly present researchers with new and interesting experiments. Avenues for exploration include corporate tax rate changes and the COVID-19 pandemic government responses. International settings will also prove useful as more countries legalize repurchases because repurchases are often regulated and disclosed differently outside of the United States. In sum, though recent studies have significantly enriched our understanding of the causes and consequences of repurchase transactions, many questions remain to be answered by future researchers.
This post comes to us from professors Alice A. Bonaime and Kathleen M. Kahle at the University of Arizona. It is based on their recent article, “Share Repurchases,” available here.