Share repurchases and long-term dilution: firm characteristics and industry differences.
The year 1982 was a defining year for share repurchases. It was in November of that year that the U.S. Securities and Exchange Commission adopted Rule 10b-18 ("Safe Harbor" for Issuer Repurchases). While heretofore share repurchases were not illegal, this rule provided a voluntary "safe harbor" from liability for manipulation when a company purchased its shares in accordance with the Rule's specification for manner, timing, price and volume conditions. (1)
The significance of the rule was not lost on corporate America as the use of share repurchases took off. Indeed, Grullon and Michaely (2002) document that the amount spent on share repurchase programs tripled within a year after its approval. With the exception of a few years during the 2008 global financial crisis, the rapid growth continued. Exhibit 1 presents a plot of the dollar volume of aggregate share repurchases for the Standard and Poor's Compustat active dataset from 1993 to 2011, along with an exponential (expon) trend line. The dollar value of repurchased shares grew from $29 billion to $642 billion, reflecting an average annual rate of growth of 25%. And the trend continues unabated as stories about share repurchases keep appearing in the financial press. "Flush with record levels of cash, the biggest U.S. companies have invested hundreds of billions of dollars this year--not in new factories, but in their own stock (Linebaugh 2012)."
This unabated trend of repurchase activity, coupled with financial press coverage, creates the perception that the number of shares outstanding is declining. For instance, when Apple Inc. made an announcement during the 2014 second quarter earnings report that it would spend an additional $30 billion to repurchase its own stock, the Associated Press stated that "[t]he company's escalating investment in its own stock also could increase the price by reducing the number of outstanding shares. That reduction increases earnings per share, a key yardstick on Wall Street to appraise a company's value." (2)
Are companies actually reducing their share count over time? It has been shown that, at the aggregate level, the number of shares outstanding has increased (Bernstein and Arnott 2003). However, very few studies have rigorously examined the long-term changes in shares outstanding at the firm level and investigated differences among industries.
In this paper, we go beyond the cursory implications drawn from the apparent strong trend in share repurchases and examine the associated effects on equity holders' proportionate ownership claims at the firm level. Knowledge of the differences across firms enhances the existing literature by removing the incorrect perception that most firms can be characterized as decreasing the number of shares outstanding over the long term. This is even more important given the misrepresentation of the impact on share repurchases by the popular press. An example comes from a recent Washington Post article. (3)
'Corporate profits are very high, but corporations are not expecting a huge burst of growth,' said Ben Inker, co-head of asset allocation at GMO, an investment-management firm. 'Given that they're not expecting a lot of growth, there isn't a lot of reason to invest. So they're finding ways of getting money back to shareholders.... It somehow feels scarier if they borrowed the money to buy back stock than if they had some investment opportunities,' Inker said. 'That somehow seems more sustainable than just levering up to reduce the share count.' (3)
Using a large dataset representing nine major industries, we demonstrate that most companies do not reduce their share count over the long run. While publicized share repurchases convey the illusion of a falling share count, frequent share issuances more than offset the number of shares repurchased, resulting in a net issuance of shares. This practice of net issuance reduces a shareholder's proportionate ownership claim, resulting in what we term a net dilution. We compute net dilution at the firm level and determine the extent of the net dilution for both an aggregate sample of firms and across individual industries. Interestingly, we find that significant industry differences exist.
We find that firms experiencing high net dilution (high diluters) have characteristics that distinguish them from firms experiencing low net dilution (low diluters), and we build a financial profile of high diluters and low diluters. Knowledge of the common characteristics of high-diluting firms should help investors and portfolio managers to identify these firms, raise awareness of this issue and avoid the negative impact of dilution on long term shareholders. Dilution results in a leakage of value from existing shareholders to new shareholders, which might not be easily detected when share prices are rising. We find that high-diluting firms are also associated with a higher level of leakage. However, rising share prices may mislead the long-term investor by masking this leakage. A more detailed explanation of dilution and its impact follows.
NET DILUTION EXPLAINED
MOTIVES FOR REPURCHASING SHARES
Companies return cash to shareholders mainly through regular cash dividends and periodic share repurchases. Share repurchases are often viewed as a tax-advantaged means of returning cash to shareholders either because they are a more favorable tax rate or because they allow shareholders the flexibility to decide whether or not they will participate and experience a taxable capital gain or loss. (4) Firms may sometimes engage in share repurchases if management thinks its stock is undervalued. Warren Buffett (2011) notes two conditions for repurchasing shares: "[F]irst, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated." Depending on the price paid for the shares, repurchases have the potential to change the value of an existing shareholder's claim. Therefore, repurchases can be a way of signaling this to shareholders (Fried 2005 and Louis and White 2006).
Arends (2012) captures a motive for share repurchases (buybacks) that is very appealing to investors:
[B]uybacks should be good for investment returns. When a company spends surplus cash buying back its stock on the open market, it reduces the overall share count. That gives every remaining investor a slightly bigger proportionate stake in the company. With a lower share count, earnings per share increase.
Stock repurchases reduce the number of shares outstanding and mitigate the dilutive effect of exercising stock options. Bens et al. (2003) and Oded and Michel (2008) note that managers may even start repurchasing their stock in anticipation of the exercise of stock options.
REPURCHASES AND THE MYTH OF SHARE REDUCTION
Bernstein and Arnott (2003) examine aggregate corporate earnings and dividends relative to Gross Domestic Product (GDP). They find that since 1929, nominal aggregate corporate earnings growth has tracked nominal GDP growth; the corporate earnings/GDP ratio was constant at 8-10%. Nevertheless, per-share earnings and dividends can only grow as fast as GDP if the number of shares outstanding does not increase. Entrepreneurial capitalization "creates a 'dilution effect' through new enterprises and new stock in existing enterprises" (Bernstein and Arnott 2003). Consequently, per-share earnings and dividends must grow slower than the overall economy.
One way to mitigate the "dilution effect" would be to decrease the number of shares outstanding with share repurchases. Given the increased use of share repurchases since 1982, one would think that over time, companies would experience a net reduction in the number of shares outstanding. Using aggregate data from 1925 through 2002, Bernstein and Arnott (2003) find just the opposite. If shareholders had a notion that share repurchases were replacing dividends, it was an illusion. The reality was that shareholders had been experiencing a "slippage" or dilution of about 2% per year in the per share growth of earnings and dividends. Furthermore, with the exception of the period of the late 1980s, the annual slippage, in aggregate, was almost constant. Unfortunately, aggregate data do not allow industry-specific conclusions to be drawn. In order to derive industry-related conclusions, it is necessary to analyze dilution at the firm level.
The financial press has begun to voice increasing skepticism about share repurchases and their commensurate reduction in the number of shares outstanding. Reilly (2013) notes that, at best, share repurchases might simply be offsetting the dilution caused by stock-based compensation. Furthermore, Hogan (2013) raises the specter that in spite of the common perception, net share repurchases--share repurchases net of issuances--might not be happening.
Companies are repurchasing more stock than ever, but it's not easy to keep tabs on those that actually are reducing share count ... While the 500 largest U.S. public companies have repurchased about a quarter of their equity's dollar value since 1998, the number of shares outstanding actually grew more than 7% in that time, reports S&P Dow Jones Indices (us.spindices.com).
WHY DILUTION MATTERS
Companies issue additional shares for a variety of reasons including: financing acquisitions, recapitalizing the company, obtaining shares for stock-based management compensation, etc. Share issuances can occur in a myriad of ways: seasoned equity offerings (SEO), financing for mergers and acquisitions, private placements, convertible debt, warrants, direct purchase plans, rights issues and employee options, grants and benefit plans.
Though SEOs are relatively rare, issuances of stock, net of repurchases, are not. Fama and French (2005) find that "[d]uring 1973 to 1982, 54% of our sample firms make net equity issues each year, rising to 62% for 1983 to 1992 and 72% for 1993 to 2002." Even though these annual net issuances might be small, their cumulative dilutive effect can be insidious.
Issuances can cause dilution, and dilution is costly. It redistributes some of the firm's value from existing shareholders to outsiders or to a minority of existing shareholders or insiders. While this is true for both stock-based compensation and SEOs, SEOs create an additional cost. Brealey, Myers and Allen (2011) note: "Economists ... have generally found that the announcement of the issue [of common stock] results in a decline in the stock price. For industrial issues in the United States this decline amounts to about 3%." Furthermore, "it appears that the long-run performance of companies that issue shares is substandard (Brealey, Myers and Allen 2011)."
The negative consequences of dilution are difficult to detect without a closer look that incorporates relative per-share performance. Traditional financial analysis using firm level data such as total sales, operating income, market capitalization and nominal share price increases is frequently inadequate. Growth in these metrics is often taken as positive evidence of successful management, but this approach may fail to recognize the decline in a shareholder's proportionate claim on the firm caused by net dilution.
MEASURING NET DILUTION
Dilution indicates that a shareholder's proportional claim on the firm has declined owing to shares given to outside shareholders. If there is no dilution, the share price and the firm's total market value will grow at the same rate. If dilution occurs and the firm's total market value stays constant, the dilution will be easy to detect. However, if dilution occurs when the total market value and the share price are growing, the percentage increase in the share price will be less than that for the total market value. Shareholders might be misled by the increase in the share price and not realize that their proportional ownership has declined.
Share issuance transactions are dilutive. The antidote would be a commensurate number of share repurchases, which would offset and potentially eliminate dilution's costly effects. (5) But a net issuance, in excess of share repurchases, leads to a decline in proportional ownership. Bernstein and Arnott (2003) measure net dilution by the ratio of the growth in total market value to the growth in the share price. This ratio captures the "slippage" of share ownership value caused by an increase in the number of shares outstanding. In essence, it measures the value erosion a shareholder experiences due to the issuance of additional shares, net of repurchases. Following Bernstein and Arnott (2003), we measure a company's net dilution as follows:
NET DILUTION = (proportionate increase in total market value/ (proportionate increase in the stock price) X 100 (1)
A net dilution value greater than 100 indicates that the net number of shares has increased.
NUMERICAL EXAMPLES OF DILUTION
Using Equation 1, we demonstrate the measurement of dilution with two numerical examples. Exhibit 2 presents a numerical example of dilution resulting from the exercise of stock options. Suppose the market value of a firm's equity increases from $1,000 to $1,100. Given 100 shares outstanding, the price per share would increase from $10.00 to $11.00. Now suppose as part of compensation, management has 10 stock options to purchase shares at an exercise price of $10.00 per share. Owing to the exercise of the options, the share count would increase from 100 to 110. The cash contributed in the process of exercising the options increases the market value of the firm by another $100. The total equity value is now $1,200. However, the increase in the number of shares outstanding creates net dilution and lowers the share price from $11.00 to $10.91. Using Equation 1, the resulting net dilution is:
NET DILUTION = ($1,200/$1,000/$10.91/$10.00) x 100 = 110
In the parlance of Bernstein and Arnott (2003), shareholders have experienced slippage in share ownership value of 10%. A shareholder observes an increase in share price from $10.00 to $10.91 and may not realize the slippage that has occurred.
Exhibit 3 illustrates dilution resulting from issuing shares to finance a project. Consider an allequity firm initially worth $1,000, with 100 shares outstanding, and a share price of $10.00. The firm has a project worth $120.00. The project costs $110.00 to implement and is financed internally, providing a NPV of $10.00. The positive NPV increases the share price by $0.10 to $10.10. After the firm accepts the project, the firm's value increases to $1,010. Both the firm value and the share price increase by 1%. There is no "slippage." Using Equation 1, the net dilution is:
NET DILUTION = ([$1,010/$1,000]/[$10.10/$10.00]) x 100 = 100 (2)
If the firm finances the project externally by issuing shares to new shareholders, it incurs issue costs equal to 4% of gross issuance ($4.58). This increases the total cost to $114.58 and causes the NPV of the project to decline to $5.42. The increase in the share price for the old shareholders is now $0.0542 ($5.42/100), and each old share will be worth $10.05. Since old and new shareholders are treated equally, the firm will need to issue 11.4 shares at $10.05 per share to raise the $114.58. The firm is now worth $1,120 (initial value + NPV + cash raised from new shareholders). With 111.4 total shares outstanding, the per-share value is $10.05. The value of the firm increases by 12%, but each share increases by only 0.54%. Again, using Equation 1, the net dilution is:
NET DILUTION = ([$1,120/$1,000]/[$10.05/$10.00]) x 100 = 111 (3)
There is "slippage" equal to 11%. Again, a shareholder observes an increase in share price from $10.00 to $10.05 and may not realize the slippage that has occurred.
We collect data on 894 firms over 21 years (18,774 firm-years), ending in 2011 and covering the 2008 global financial crisis. Our sample consists of firms in the Compustat database. We require firms to be traded on the NASDAQ, NYSE or AMEX stock exchanges. Per Chen and Wang (2012), we exclude firms classified as American Depository Receipts (ADR), Real Estate Investment Trusts (SIC 6798, REITs) and closed-end funds. We eliminate very small firms by requiring companies to have sales of at least $50 million in the most recent calendar year, a share price of at least $3.00 and a market value greater than or equal to $50 million.
The impact of dilution compounds over time, diminishing proportional ownership. Its greatest impact will be on the long-term shareholder. The purpose of the study is to investigate the impact of dilution on firms that have been in existence for a long period of time. Therefore, we require companies to have 21 years of annual calendar year data for shares outstanding. This requirement introduces a survivorship bias into our sample as it does in all time-series studies. This would be more problematic if it created a selection bias against certain industries, such as technology. However, our dataset includes a significant representation from all industries, including the technology industry. Therefore, our data does not appear to suffer from selection bias. The shares are adjusted for stock dividends and stock splits. This results in a global data set (G) of 894 firms.
In order to investigate possible industry effects, we divide the global data set into industry groupings using the ten broad economic industry sectors defined by Compustat. (6) Since in our sample there are only nine firms in the Telecommunication Services industry, we combine these firms with the 113 firms in the Information Technology industry to create a "Technology" industry consisting of 122 firms. Exhibit 4 lists the number of firms in each industry.
In order to investigate the differences between high diluters and low diluters, we examine a number of financial characteristics relating to size, growth, profitability, leverage, activity (turnover), capital intensity, liquidity, market value, dividend policy and level of systematic risk. Dividend data is somewhat limited. It exists for 63 of 102 Financials, 8 of 67 Utilities, 52 of 58 Energy companies and all of the companies in the other six industries. Therefore, for dividend measures only, the global sample size decreases to 790 from 894. (7) Exhibit 5 presents the characteristics, along with their respective financial measures and abbreviations. Summary statistics for these measures are provided in Exhibit 11.
Using Equation 1, we partition the firms in two ways. Using percentage rankings, we first partition the global set (G) into thirds by net dilution: G-High, G-Middle and G-Low. We then analyze these groups using the previously noted characteristics.
Using percentage rankings, we also partition each industry (I) into thirds using net dilution: 1-High, 1-Middle and 1-Low. Within each industry, we again analyze 1-High, 1-Middle and 1-Low groupings by firm characteristics.
The distributions of the data for most of our financial measures are skewed. Hence, we use medians as a measure of central tendency. In addition to ranking firms by net dilution, we also rank them with respect to each financial measure and use the Spearman rank correlation to measure the relationship between net dilution and each financial measure.
Using firm-level analysis, we find that the vast majority of firms engage in dilution, with 632 (71%) of the 894 firms experience cumulative dilution by 2011. The median net dilution is 131.2 by the end of the twenty year period, reflecting a compounded annual rate of about 1.4% per year. Although consistent, our median annual rate of net dilution is lower than the 2% reported by Bernstein and Arnott (2003), who used aggregate data for the period 1925-2002.
There is a substantial difference in the annual net dilution rate between high and low diluters. High diluters experience a compounded annual net dilution rate of 5.5%, while low diluters have experience a compounded annual net dilution rate of about -0.8%. In addition, the difference in net dilution between high and low diluters occurs consistently over the twenty-year period, as revealed by Exhibit 6. Note the asymmetry relative to the middle dilutee Compared to the middle, the difference between the high diluter and the middle diluter is far greater than the difference between the low diluter and the middle diluter.
Exhibit 7 contains a frequency table for the net dilution as of 2011. The data for net dilution are highly skewed, with over 20% of the companies having a 2011 net dilution measure equal to or exceeding 250, as compared to a global median of 131.2. (8)
Exhibit 8 depicts a time-series of the net dilution by industry. Eight of the nine industries experience dilution. Consumer Staples is the consistent exception.
A chi square analysis of frequencies for the global sample reveals that the proportional representation of low, middle and high diluters is not the same for all industries. The significance level is less than 1%. Exhibit 9 provides an analysis of the frequencies within each industry and within each major dilution grouping. It reveals that low, middle and high diluters are not uniformly distributed for Consumer Discretionary, Consumer Staples, Industrials, Technology and Utilities industries (row p-value). Materials and Health Care are exceptions. This is confirmed by a chi square test of proportionality for low and high diluters (column p-value). Overall, this indicates that, within industries, the prevalence of high and low diluters differs from that of the global sample.
In conjunction with our analysis of net dilution, we analyze 20 years of annual percentage changes in shares outstanding for all firms. Exhibit 10 presents the frequency and cumulative distributions for all firm-years. Consistent with Fama and French (2005), the frequency distribution reveals that large percentage increases in shares outstanding are rare. The cumulative distribution shows that a very large proportion of the distribution is reached at very low percentage changes in the number of shares outstanding. Indeed, 76% of the annual percentage changes in shares outstanding are less than or equal to 2%, the aggregate median being about 0.4%. By comparison, the Technology industry has the highest median annual percentage change (1%) in shares outstanding; Consumer Staples has the lowest median (0%).
We now discuss our findings for net dilution overall, as well as for the ten characteristics using the following three exhibits. Exhibit 11 contains summary statistics for low, middle and high diluters. Exhibit 12 presents median characteristics for low, medium and high diluters by industry. Finally, Exhibit 13 provides Spearman rank correlations for both the global sample and the nine industries.
We would expect larger companies to have more stable revenue and cash flow streams. We also expect this stability to have a positive effect on the value of a large company's reputation, providing it with more debt financing opportunities at better terms than those available to small companies. Because of the higher level of stability in the revenue and cash flow streams, larger companies would be expected to rely less on stock-based compensation. Ceteris paribus, we would expect larger companies to dilute less.
Using Spearman rank correlations, we examine the relationship between size and net dilution at the beginning and end of the sample period. (9) Exhibit 13 reveals that high diluters are smaller companies in 1991, whether we measure size using log(sales) or log(total assets). In 2011, there are no differences in size in terms of sales, but we find that high diluters are larger as measured by total assets.
Exhibit 12 reveals that for seven of the industries, the median size of the firm in 1991, measured by log(sales), is lower for high diluters. This result also holds when using total assets as a measure of size, with eight of the nine industries having lower size in 1991 associated with higher dilution. However, the Spearman rank correlations (Exhibit 13) are not statistically significant for more than four of the industries in either case. While not statistically significant, the sign of the coefficient does support the interpretation that higher dilution is more prevalent among firms that were smaller in 1991, with eight of the nine industries having a negative rank correlation for both measures of size.
The industry results for 2011 are mixed. The Spearman rank correlation for Health Care is negative and significant. Five of the industries have positive signs, while four industries have negative signs. Only three of the industries have Spearman rank correlations that are significant. See Exhibit 13.
Our results for 1991 are consistent with our expectations that smaller firms would dilute more. However, this is not the case for the 2011. Perhaps after 20 years the revenue and cash flow streams of the previously-smaller firms have stabilized, allowing these firms to rely less on equity financing or equity-based compensation. An examination of the relative sizes of the high-diluting and low-diluting firms provides indirect evidence that the small firms have stabilized. Low-diluting firms are much larger than the high-diluting firms when measured by both total assets and sales in 1991. For example, in 1991 median total assets for low diluters was $692 million, while the same figure for high diluters is $391 million. However, by 2011 low-diluting firms are smaller than high-diluting firms when measured by total assets, $2.94 billion versus $3.93 billion, respectively. The low-diluting firms are still somewhat larger than high-diluting firms when measured by sales, although the difference is much smaller.
Rapidly growing firms often need external financing. However, if their cash flow streams are less stable than those of larger, slower growing firms, they may have to rely more heavily on equity financing. At the same time, they might have to rely more on stock-based compensation. We would expect more rapidly growing firms to experience a higher level of dilution than firms that grow more slowly.
For each company, we compute the average annual growth rate for total assets and sales. Exhibit 14 reveals that the median total assets grew much faster for high diluters than for low diluters. Moreover, the growth rates in sales and assets are positively related to dilution. The Spearman rank correlation is 0.420 for sales and 0.426 for assets, and both are statistically significant at the 1% level. These findings are consistent with our expectations for growth, as well as those reported for size.
Additionally, overall the median annual growth rate for total assets (10.2%) exceeds the growth rate for sales (8.7%). (10) While all major groupings experience an upward trend, the trend for high diluters is more pronounced.
The industry results for the growth variables demonstrate an important link to the level of dilution. In Exhibit 13, the Spearman rank correlations are statistically significant for growth in both assets and sales for all nine industries. Moreover, for all industries, the positive sign of the correlation is consistent with the global finding and the level of correlation is high. Additionally, in all industries and for both measures of growth, the median for the high diluters is greater than the median level of growth for the low diluters. This provides strong evidence that, regardless of industry, faster growing firms are more likely to be high diluters.
The Pecking Order Theory (Myers 1984) suggests that less profitable firms are more reliant on external financing. In addition, less profitable firms might have to rely more on stock-based compensation. On this basis, we would expect less profitable firms to dilute more by issuing more shares for financing or stock-based compensation.
Consistent with our expectations, high diluters are not as profitable as low diluters. Exhibit 11 shows that in the aggregate the median operating margin is 10.1%; it is 10.7% for low diluters and 9.8% for high diluters. Furthermore, the Spearman rank correlation is -0.097, and it is statistically significant at the 1% level. Moreover, the median ROA is 11.5% for the low diluters but only 6.4% for the high diluters; the -0.464 Spearman rank correlation is statistically significant at the 1% level. Exhibit 15 reveals that the spread between high diluters and low diluters for ROA is consistent across all years.
The profitability evidence is consistent with the finding that assets are growing faster for high diluters than for low diluters. The rapid growth rate in assets and the lower level of profitability suggests that high diluters appear to be focusing on asset growth at the expense of profitability, resulting in diminishing marginal returns to scale. (11)
Profitability appears to have a large influence on dilution in many of the industries. The Spearman rank correlations in Exhibit 13 are statistically significant for eight of the nine industries when we measure profitability by ROA and five of the nine when we measure profitability by the operating margin. The sign of the correlation is negative for all nine industries when using ROA as the proxy for profitability and negative in eight of the industries when using operating margin. The industry results are consistent with the Pecking Order Theory and a greater use of stock-based compensation for low profitability firms.
The Pecking Order Theory implies that firms with a high degree of financial leverage tend to have stable cash flow streams. These firms would choose to issue debt first and be less likely to issue shares. This suggests that firms with higher debt levels would dilute less.
In contrast to our expectations, we find that high diluters tend to be more levered than low diluters, and the higher leverage is consistent for each year in the 21-year period. The long-term debt-to-capital ratio is 23.1% for low diluters as compared to 37.6% for high diluters, and the Spearman rank correlation (0.243) is statistically significant at the 1% level. Recall that high diluters' assets grow faster than those of low diluters. However, since they are less profitable, they need to finance a greater proportion of the assets externally, frequently with debt. Our findings linking high growth and high debt are partially consistent with those of Fama and French (2005 570) who find that high growth firms, regardless of profitability, are issuing both debt and equity. Interestingly, the lower level of profitability does not appear to be a hindrance to the additional borrowing.
The issuance of shares for stock-based compensation might provide a clue for the failure to support what the Pecking Order Theory suggests about the order of external financing. The Pecking Order Theory's explanation of the negative effects associated with equity financing relates to the asymmetric information associated with SEOs. However, we find that a significant proportion of the shares issued, and hence, the related net dilution, is likely coming from stock based compensation and not SEOs. Taken individually, these smaller but more frequent issuances might well be below the threshold needed to produce the negative effects of asymmetric information so often associated with SEOs.
The Spearman rank correlations between leverage and dilution are significant for five of the nine industries. The positive sign of the correlation is consistent in all nine industries, and the sizes of the correlations appear to be large. See Exhibit 13.
The industry impact for leverage is particularly interesting. For example, as expected, debt-to-capital ratios are high for Utilities compared to other industries. The median debt-to-capital ratio for low diluters for Utilities is 50.6% versus 52.1% for high diluters. On the other end of the scale, the median debt to capital ratio for low diluters in Technology is 9.71% compared to 19.11% for high diluters, both well below the global median for low diluters (23.06%). While the magnitude of the ratio points to an industry difference, high diluters have higher debt than low diluters in eight of the nine industries, the exception being Consumer Staples, the lowest diluting industry. The Consumer Staples industry also has the lowest correlation by far, and it is not significantly different from zero.
Activity (Turnover or Efficiency)
All other things being equal, companies with a lower total asset turnover would be expected to have a lower level of profitability, creating a need to raise cash externally to finance their operations. Hence, we would expect companies with lower turnover to dilute more.
Our analysis reveals that high diluters indeed have lower asset turnover compared to low diluters. The median asset turnover for high diluters is 0.8 as compared to 1.2 for low diluters. Additionally, the negative Spearman rank correlation (0.276) is statistically significant at the 1% level. This is consistent with the observation that total assets are growing faster for high diluters but without any commensurate economies of scale. This leads to the lower efficiency in sales generation.
The industry results on the impact of asset turnover are somewhat mixed. The negative sign of the correlation is consistent with the global sample in six of the nine industries, while the Spearman rank correlation is statistically significant in four of the nine industries. See Exhibit 13.
We associate capital intensity with mature companies having a higher proportion of tangible assets, giving them a lower cost financial distress. This should allow these companies to have greater access to debt financing, lessening the need for equity financing. Therefore, we would expect a lower level of dilution for capital intensive companies.
We use the proportion of property, plant and equipment-to-total assets (PPE/TA) as a measure of capital intensity. In contrast to our expectations, high diluters do not seem to be different from low diluters. High diluters and low diluters have PPE/TA ratios of 24.7% and 23.4%, respectively, and the Spearman rank correlation, though positive, is close to zero and not significant.
For the industries, the PPE/TA results are mixed. Exhibit 13 reveals that four of the industries have a positive sign and five have a negative sign. For seven of the industries, the magnitudes of the Spearman rank correlations are small and not significant.
Nevertheless, there are two interesting cases. In contrast to our expectations, the Spearman rank correlation for Energy has a positive sign, is large (0.417) and is significant at the 1% level. In contrast to Energy and consistent with our expectations, Health Care's Spearman rank correlation is also significant, large and negative (-0.309). Many of the companies in the Health Care industry have investment expenditures consisting of research and development, which is not capitalized as is property, plant and equipment. One might wonder if the results for Health Care would change if these companies capitalized research and development expenditures.
The situation with respect to liquidity is complex. Our two measures of liquidity are based on cash, the level of which is subject to seasonality and substantial volatility. Ex ante, our expectations are indeterminate.
When measured by cash/TA, the evidence regarding liquidity is mixed. Overall, high diluters do not seem to be different from low diluters. This suggests that, overall, firms do not issue shares to increase cash balances relative to total assets. Energy and Financials are two interesting cases. The Spearman rank correlations for both are negative, large and statistically significant at the 1% level for Energy (-0.417) and at the 5% level for Financials (-.213).
We also measure liquidity using the cash/sales ratio. High diluters tend to have more cash as a percent of sales, and the Spearman rank correlation, while not high (0.148), is statistically significant at the 1% level. For the individual industries, the Spearman rank correlations are positive in seven but significant in only two industries, Consumer Discretionary and Materials. Overall, we do not think that liquidity, as it relates to cash balances, is a distinguishing characteristic of diluting firms.
Ceteris paribus, diluting firms have a propensity to transfer wealth to outside shareholders. Expectations of this behavior continuing should make share prices less valuable. Hence, we would expect that high diluters would have lower price-to-book ratios. Indeed, Exhibit 11 reveals that high diluters are valued less in terms of the price-to-book ratio: 2.1 for high diluters versus 2.7 for low diluters. Furthermore, the negative Spearman rank correlation (0.154) is statistically significant at the 1% level.
The industry results shown in Exhibit 13 generally confirm the negative correlation between dilution and market value. The Spearman rank correlations are negative in six of nine industries and statistically significant in five. The magnitudes of the Spearman rank correlations for the remaining three industries are not meaningful.
There appears to be a consistent theme. High growth in assets relative to sales is associated with low asset turnover. Coupled with low profitability, this increases the incentive for higher leverage. This lower financial performance on a per-share basis is consistent with a lower per-share market-to-book value.
Taking account of dilution by distinguishing between the firm's total market value and share price provides better insight on a firm's financial performance. Consider a plot of relative market value (MV) scaled by relative sales (S):
[[MV.sub.t]/[MV.sub.0]] / [[S.sub.t]/[S.sub.0]] x 100
Exhibit 16 reveals that the time-series plot for this measure is non-decreasing for all levels of dilution. If market value and sales grow at approximately the same rate, the time-series should be flat. If market value grows faster than sales, the plot will be upward sloping.
Now consider a plot of relative share price (P) scaled by relative sales (S):
[[P.sub.t]/[P.sub.0]] / [[S.sub.t]/[S.sub.0]] x 100
In contrast to Exhibit 16, Exhibit 17 shows that there is a clear downward trend for high diluters. This is consistent with the evidence for price-to-book. Overall, the growth in the share price falls considerably short of the growth of the firm's sales. Dilution matters! A financial analysis based on the overall company performance might lead to a more favorable conclusion than is warranted by an individual investor's per-share performance. We find similar results using total assets instead of sales.
All else equal, if companies retain earnings to reinvest in positive net present value projects, they should have less need for external financing. As such, we would expect a lower level of dividends paid to be associated with a lower level of dilution.
We examine the propensity to pay dividends using the dividend yield and the dividend-to-sales ratio. (12) Surprisingly, high diluters tend to pay lower dividends, whether measured as a percent of sales or as the dividend yield. High diluters pay a median of 0.4% of sales in dividends compared to 1.6% for low diluters. The -0.311 Spearman rank correlation is statistically significant at the 1% level.
Lower dividends should allow for higher levels of asset purchases for faster growth in sales and earnings. But for high diluters, these asset purchases do not appear to generate a sufficient levels of sales (turnover) or profitability, and, as we have seen, the retained earnings do not appear to be a substitute for debt financing. This is consistent with the findings of Arnott and Asness (2003), who find that lower dividend payouts are associated with lower earnings growth.
The median dividend yield is 0.3% for high diluters compared to about 1% for low diluters. The Spearman rank correlation is -0.204 and is statistically significant at the 1% level. Using our adjusted sample, 104 of 790 companies (13.2%) do not pay dividends over the sample period. Of that number, 52% are high diluters and only 11% are low diluters. Of all the low diluters, 3.8% (11/287) do not pay dividends over the 21-year sample period, whereas 22.1% (54/244) of high diluters do not pay dividends.
The industry results for both measures of dividends are similar to the global results. The sign of the dividend/sales measure is also negative for all industries, and the dividend yield is negative for seven of the nine industries. While the direction is consistent, the correlations are statistically significant for dividend/sales in five industries and for dividend yield in four industries.
The value of an option increases with an increase in the risk of the underlying asset. Hence, stock options should have more value to managers in higher-risk firms. We would expect stock-based compensation and the related dilution to be positively related to systematic risk.
We use beta as a measure of systematic risk. Compustat estimates beta using five years of monthly returns for both the company and the S&P 500. The database provides betas for the five most recent years. Our analysis relates to the medians of the five-year average for each company. High diluters have higher median betas, 1.28 versus 1.05 for low diluters. The Spearman rank correlation (0.141) is statistically significant at the 1% level. Not only do low diluters have a lower level of systematic risk, but, as previously noted, they have a higher median price-to-book ratio than that of high diluters.
For all nine industries, the signs of the Spearman rank correlations are positive and the correlations are significant in five of the industries. For all nine industries, the median beta for high diluters is above the median for low diluters. The range of values for betas highlights the differences among industries, with low diluters in Utilities having a beta of 0.59 and low diluters in Materials having a beta of 1.28. For the high diluters, the range goes from 0.61 in Utilities to 1.72 in Materials. The findings for systematic risk are also consistent with our findings for leverage. High diluters have higher levels of leverage, which amplifies the systematic risk for the shareholders.
DISCUSSION AND CONCLUSION
The share repurchases reported in the financial press and in companies' 10-Ks would lead an investor to expect a reduction in shares outstanding. But small and frequent issuances tied to stock-based compensation and occasional SEOs more than offset these repurchases. Aside from one industry, the notion of reducing the share count with share repurchases is an illusion; dilution is the reality.
We find that most firms in our sample (71%) engage in net dilution, with the median rate equal to about 1.4% per year. More importantly, the extent of the dilution varies among industries. Utilities, Energy, Financials and Technology industries are high diluters. Interestingly, the Consumer Staples industry is the sole non-diluting industry, with a median rate of dilution of about 0.5% per year.
Dilution matters, and over the long-term it is costly. It transfers wealth from existing shareholders to outsiders by reducing shareholders' proportionate ownership claim on the firm. While this can occur via stock-based compensation or SEOs, the stock-based compensation is more insidious.
Growth is often revered as a virtue. For high diluters, both total assets and sales grow faster than they do for low diluters. While for the typical firm assets appear to be growing faster than sales, the rapid growth rate in assets relative to sales is much more pronounced for high diluting firms. This rapid growth has a downside for high diluting firms. They generate fewer sales per dollar of assets, suggesting that these firms are experiencing diminishing marginal returns to scale. Worse still, the high diluting firms are not as profitable as low diluting firms. And because of dilution, the growth rate in per-share earnings must be less than the growth rate in earnings for the firm as a whole. Eventually, these realities are reflected by the market in the price-to-book ratio. In addition, high diluting firms are more highly levered, return less cash to shareholders in the form of dividends and have a higher level of systematic risk. These conclusions are summarized in Exhibit 18, which presents a financial profile of high diluting firms.
Dilution and its costly effects differ among the industries. Moreover, irrespective of industry, the differences between high diluters and low diluters persist. The results are not driven by an industry effect.
In this paper, we do not address the conjecture that shareholders' returns (or value creation) might have been lower had the dilution not occurred. Still, the evidence we present does not support this conjecture. High diluters have lower profitability, lower dividends, lower turnover and lower price-to-book ratios despite having higher leverage and higher systematic risk. Furthermore, the share performance relative to sales and assets for high diluting firms is substandard.
We think that there is a need for additional research. Why do companies dilute? Why do they not dilute? Why are companies in some industries more likely to dilute? When companies do repurchase shares, why do they not repurchase enough shares to prevent dilution entirely? If stock options are the primary cause of the dilution, we find, does the expense recorded for stock options adequately reflect the cost of the dilution? Do shareholders react sufficiently when net dilution occurs? Does dilution occur in "clumps" or "waves" as is frequently observed for mergers and acquisitions?
Investors, financial analysts and portfolio managers need to look beyond financial performance at the firm level and assess performance in light of the per-share effects. Moreover, we think there needs to be a serious debate about the wisdom of pursuing corporate policies that lead to dilution. Finally, we think there needs to be a renewed discussion of the efficacy of share-based management compensation.
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|Title Annotation:||p. 1-26|
|Author:||Root, Thomas; Rozycki, John; Inchulsuh|
|Publication:||Quarterly Journal of Finance and Accounting|
|Date:||Dec 22, 2014|
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