Common stock repurchase and market signalling

Topics: Stock market, Stock, Corporate finance Pages: 24 (3287 words) Published: September 24, 2013
Journal

of Financial

COMMON

Economics

9 (1981) 139-183.

STOCK REPURCHASES

North-Holland

Publishing

Company

AND MARKET SIGNALLING

An Empirical Study*
Theo VERMAELEN
lJ/niversity

of British Columbia, Vancouver, BC, Canada V6T 2 W5

Received January

1980, final version

received January

1981

This paper examines the pricing behavior
of securities of firms which repurchase
their own
shares. The results are consistent
with a market in which investors price securities such that
expected arbitrage profits are precluded. The results are also consistent with the hypothesis that firms offer premia for their own shares mainly in order to signal positive information, and that
the market uses the premium, the target fraction and the fraction of insider holdings as signals in order to price securities around the announcement
date. The observation
that repurchases
via
tender offer are followed by abnormal
increases in earnings per share and that mainly small
firms engage in repurchase tender offers, provides further support for the signalling hypothesis.

1. Introduction
The purpose of this study is to examine the price behavior of securities of firms which buy back their own shares in the open market or via a tender offer and announce the repurchase decision in the Wall Street Journal. The U.S. is one of the few countries in the world which allows firms to make tender offers for their own shares at a price above the market price. The rather negative attitude

of legislators
of other countries
is generally
motivated by a stated desire to protect non-insider
investors. The argument
is that insiders could manipulate
prices by giving false ‘signals’ to the market
or they could expropriate
bondholders
by reducing the size of their claims on
the assets of the firm. In spite of some outcries for legislation,’ repurchases in
the U.S. have been left largely untouched
by the S.E.C.
*This paper is adapted from my dissertation
at the University
of Chicago. I would like to
thank my committee ~ Eugene Fama. Jon Ingersoll, Roger Kormendi, Merton Miller, Myron
&holes and especially my chairman
Robert Hamada
for their support
and encouragement.
Helpful comments
on earlier versions were received from Giovanni
Barone Adesi, Michael
Bradley (referee), Rob Heinkel, Ron Masulis, an anonymous
referee for this Journal
and,
especially, Michael Jensen. The generous financial support of the Interuniversitair College Voor
Doctorale
Studies in Managementwetenschappen
is gratefully acknowledged.
The author takes
responsibility
for all remaining errors.
‘For example, to quote Guthart
(1965, p. 53): ‘At the present time, the SEC has no specific requirements
concerning
share repurchases,
and the body of corporate
law concerning
this
particular
activity is not clear regarding
the potential
conflict of interest that may exist.
Conclusive detinitions of responsibility
in this area are urgently needed,’

0304-405)3/81/000~0000/$02.50

0 North-Holland

Publishing

Company

7: Vermaelen,

140

Stock

repurchases

and market

signalling

One of the objectives of this study is to investigate whether an argument could be made for increased regulation
on the basis of observed effects of a
repurchase on the wealth of the different classes of security holders. Previous research is inconclusive
and contradictory
with respect to the motivation
and
effects of common
stock repurchases.
Several studies [e.g. Young (1967)
Stewart (1976), Marks (1976) and Lane (1976)] suggest ‘weak-form’ market inefficiencies2
and/or
suffer from methodological
weaknesses.
Two more
recent studies are those of Dann (1981) and Masulis (1980a). They both report abnormal
price increases after a repurchase
announcement
but they
provide different explanations
for the observed returns.
With regard to the explanation
for any observed changes in stock prices,
we...
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