124  The Stock Market Is Smarter Than You Think In many cases, a stock split is indeed accompanied by positive abnormal returns to shareholders in the months prior to the split (see Exhibit 7.17).43 The abnormal returns have nothing to do with the split as such but are simply a function of self-selection and signaling. Self-selection is the tendency of com- panies to split their stocks into lower denominations because of a prolonged rise in their share price. More insightful is the abnormal return for the three days around the date of the stock split announcement, at about 3 percent.44 When managers an- nounce a stock split, they are also signaling that they expect further improve- ment in economic fundamentals. Indeed, two-thirds of companies reported higher-than-expected earnings and dividends in the year following a stock split. When performance improvements followed the split, the stock market did not react, indicating that investors had already factored them into their decisions at the time of the stock split announcement. Consistent with this pattern, companies that did not improve performance as expected in the year after a stock split saw their share prices fall.45 44 Some researchers have reported positive abnormal returns not only in the days around but in the en- tire year following a split announcement. They conclude that the market is inefficient by underreacting to stock splits; see Ikenberry and Ramnath, “Underreaction to Self-Selected News Events.” Others find that these abnormal returns do not lead to any arbitrage opportunities and that the market is efficient; see Boehme and Danielsen, “Stock-Split Post-Announcement Returns”; and J. Conrad and G. Kaul, “Long-Term Market Overreaction or Biases in Computed Returns?” Journal of Finance 48 (1993): 39–63. 45 See Fama et al., “Adjustment of Stock Prices.” EXHIBIT 7.17  Cumulative Average Abnormal Returns around Stock Splits % Month relative to split –29 –25 –20 –10 –15 15 –5 0 5 10 20 25 30 0.44 0.33 0.22 0.11 0 Source: E. Fama, L. Fisher, M. Jensen, and R. Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (1969): 1–21. 43 E. Fama, L. Fisher, M. Jensen, and R. Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (1969): 1–21. Summary  125 Myths about Value Distribution Another common misconception among executives is that share repurchases and dividends create value for shareholders. This view is often reinforced by both private and public demands from investors for companies to return more cash to shareholders, particularly as share repurchases. If you dig deeper into understanding investor demands, though, you will typically find that inves- tors want more cash distributed not because the cash distribution itself creates value, but because investors are concerned that companies will squander ex- cess cash and debt capacity on value-destroying investments. They view cash distributions as a way to impose discipline on the company’s use of its cash.46 More important, companies create value when they generate cash flows. Distributing those cash flows to shareholders cannot create additional value. That would be double-counting and akin to violating principles like the con- servation of matter in physics. So why do companies’ share prices often increase on the announcement of share repurchases or dividend increases? In some cases, investors inter- pret dividend increases as a sign that management is confident enough about future cash flow generation to commit to a higher dividend level. In other cases, investors are relieved that management is less likely to squander cash on value-destroying investments. The result is that investors raise their expec- tations of future cash flows. If these expectations are not met, the companies’ share prices will decline later. Dividends and share repurchases are merely instruments for distributing cash generated by the company’s operations. Furthermore, as we discuss in Chapter 33, decisions about cash distributions should not drive a company’s investment decisions; they should be an integral part of a company’s capital allocation that matches its investment needs, financing opportunities, and de- sired level of risk. Summary Dramatic swings in share prices sometimes lead finance practitioners to sug- gest that established valuation theories are irrelevant and that stock markets lead lives of their own, detached from the realities of economic growth and business profitability. We disagree. There is compelling evidence that valua- tion levels for individual companies and the stock market as a whole clearly reflect the underlying fundamental performance in terms of return on capital and growth. Yes, there are times when valuations deviate from fundamentals, but these typically do not last long. Evidence also shows that some widespread 46 See, for example, M. Goedhart and T. Koller, “How to Attract Long-Term Investors: An Interview with M&G’s Aled Smith,” McKinsey on Finance 46 (Spring 2013): 8–13.