Nohel and Tarhan
JFE 1998
 

Executive Summary: This paper looks at operating performance changes around stock buybacks.  Finding little overall improvement, the evidence suggests that the positive returns surrounding stock buybacks is caused by a reduction of the free cash flow problem and not so much as signaling.  Moreover, what improvement there is, is concentrated in firms with few growth opportunities.
 

The authors attempt to determine why stock buybacks are associated with positive abnormal returns.  The authors identify the two basic hypotheses that have been presented in the literature--namely a reduction of the FCF problem and signaling by management.  This paper looks at the question and concludes that the reduction of the FCF problem is the main reason for the abnormal returns. 

Lang and Litzenberger (1989) "show that the market reacts more to dividend changes at low-q firms…they argue that this evidence supports the free cash flow hypothesis rather than the information signaling hypothesis." [Summarizers note: Q is Tobin's Q, which is ratio of market value to replacement cost.  Higher Q-values have been associated with more investment opportunities and/or better management.]  The Lang-Litzenberger results have been questioned by Howe, He, and Kao (1992) as well as Denis, Denis, and Sarin (1994) but were supported by Perfect, Petersen, and Petersen (1995) after adjusting how Q was calculated.

Nohel and Tarhan sum up the foundation of their paper "If a firm's intention in announcing a repurchase is to 'signal'…that the firm's prospects are improving, then we should see a tangible improvement in operating performance relative to what was expected."
 

It is possible that stock repurchases may signal a reduction in risk.  This would also be consistent with the stock price reaction.
 

Data and methodology
The sample begins with 282 firms that had a tender offer repurchase between 1978-1991.  These offers included both "fixed price and Dutch-auction tender offers."

To "avoid imposing a survivorship bias…by requiring data only in the year prior to the repurchase."  This is because if not, only successful firms (those that did not go out of business) would be in the sample.

Performance evaluations are performed using a matched sample.  In the spirit of Barber and Lyon (1996), matching is largely based on the previous year's performance however the match is also based on several things: 

1. Previous performance
2. Industry classification
3. Q-classification (hi or low)
4. Leverage

After the matching, the sample is composed of 242 firms.

Table 1 lists the variables that were used to measure operating performance.  They are " cash flow return on assets, asset turnover, cash flow margin, Market to Book, as well as capital expenditures, asset sales, growth rates.
 

The authors find significant improvements in operating performance following the repurchases.  However, these improvements are "coming entirely from low-growth firms, and stems from a more efficient deployment of repurchasing firms' existing assets rather than from new investment opportunities."  This is found by investigating cash turnover, which improves relative to the control group.  On the other hand there is little, if any, improvement in cash-margins.  However, looking at the cumulative operating performance, repurchasers outperform their control by 23.3% for low q-firms but are insignificantly negative for high-q firms.
 

"Announcement returns were significantly related to post-purchase abnormal performance…Partitioning…reveals that this result is again generated by the low-q subsample…[indicating] that investors correctly anticipate the superior performance of low-q firms and the mediocre performance of high-q firms."  Note: Table 8 shows that low-q firms were "up" more than high-q firms looking at both the announcement returns as well as the return from the announcement to expiration return.

Another interesting regression finding was that if the stock happened to be "in-play" at the time of the repurchase (a defensive repurchase) supports Denis (1990) and are associated with negative coefficient.

The authors also find that there is a reduction in risk (as measured by both beta and standard deviation) following the repurchase.  (Table 10)

To determine whether "investors revise their expectations," the long-run (3 year) abnormal return was investigated.  There is a "mean 3-year abnormal return of 10.3% which is insignificantly different from zero.  The figures for low-q and high-q subsamples are 15.44% and 6.23% respectively, both insignificantly different from zero."

Other findings
* Leverage increases after the repurchase but is driven largely from the high-q sample
* Market to book values of low q firms remains lower than their control group
* Post repurchase performance at low q firms is correlated with assets sales which is more support for FCF hypothesis