The Economics of Stock Buybacks
Fortunately, Erica York, a senior economist at the Tax Foundation, nicely shows why stock buybacks often make sense. They tend to happen when a firm doesn’t have better investment options. Stock sellers can then use the funds to invest in firms that do have better investment options. Oh, and by the way, who owns a large percent of corporate America? Pension funds. Many workers rely on these funds for their retirement. Those tears that Schumer and Biden are shedding for workers are crocodile tears.
This is the last paragraph of David R. Henderson, “Stock Buybacks Are Good, Not Bad,” TaxBytes, Institute for Policy Innovation, March 9, 2023.
Read the whole thing, which is short.
Mar 12 2023 at 1:10pm
Quoting Bernie Sanders in the original article: “When a company purchases its own stock back, it reduces the number of publicly traded shares, boosting the value of the stock to the benefit of shareholders and corporate leadership.”
Does a buyback really boost the value of the stock? If a company is worth $10,000 and half the stock is bought back, the company becomes worth $5,000. Half the owners own half the value and the stock price is unchanged.
Mar 12 2023 at 1:22pm
If the company is buying back shares, they have to offer a higher price than the current owners value it, not a lower price, in order to get the owner to give it up (it’s the same reason wages do not fall when trade opens up between countries even if one country pays lower wages). Plus, if the value of the company is not changing, and the number of shares outstanding is falling, then the value per share (ie the price) necessarily rises.
Mar 12 2023 at 1:35pm
“If the company is buying back shares, they have to offer a higher price than the current owners value it ”
Then the value of the stock is even lower than before.
“Plus, if the value of the company is not changing, and the number of shares outstanding is falling, then the value per share (ie the price) necessarily rises.”
But the value of the company *is* changing. If a company pays cash for its stock, it loses cash.
Mar 12 2023 at 1:36pm
No. A positive number is bigger than a negative number
Mar 12 2023 at 1:44pm
“A positive number is bigger than a negative number”
Are you sure?
Seriously, back to my example. Let’s say, as you suggest, the sellers demand a higher price. The company is worth $10,000. It buys back half of its stock. To make this clear, let’s say the sellers demand double the price. The company now has nothing.
Mar 12 2023 at 2:26pm
Why do you assume that? It’s not obvious from your example.
Mar 12 2023 at 2:35pm
It’s not an assumption. It’s math: $10,000-10,000=0. Ceteris paribus does not apply.
Mar 12 2023 at 1:59pm
they have to offer a higher price than the current owners value
If the company has to overpay to buyback shares (and that is what would happen on your example if the company is initially valued at its fair price) then the stock buyback should reduce the value of the outstanding shares (once the dust settled after the demand frenzy caused by the buybacks)
Mar 12 2023 at 2:27pm
Why do you assume they’re overpaying?
Mar 12 2023 at 2:31pm
Because I am assuming that the shares are initially valued at is fair price and you said the company is paying a higher price (than my assumed initial fair value) to buy out the leaving shareholders.
I am calling “overpaying” to “paying more than the fair value” (which I am assuming was the initial share market value).
Mar 12 2023 at 2:10pm
if the value of the company is not changing
But the value of the company does change during the buyback!
The company has to transfer part of its “value” to buy out the shareholders leaving the company (they are not leaving for free).
The bought out shareholders are “leaving” the company carrying with them “value” equivalent to the fair value of the percentage they owned in the company (it could be cash, or shares of other company that the holding public company owned, or chairs or tv screens …). So, the company is left with less cash (or whatever other asset it is using to buy out the leaving shareholders) and because of that it has to have a reduced value.
Mar 12 2023 at 2:28pm
Why do you assume that?
Mar 12 2023 at 2:35pm
Jon, is not an assumption.
If the company has a value of X and uses 0.2X of this value to buy out the leaving shareholders and them retire the stock. Then the value of the company is 0.8X (which is a reduced value compared with X)
That’s not an assumption that is mathematics
[If the company does not retire the buyback stocks them you are right and the value of the company does remain the same, but so does the number of outstanding stocks so the share price should not change either way]
Mar 12 2023 at 2:27pm
Bernie Sanders has no idea what is he talking about (at least when it comes to shares buybacks).
Quoting Warren Buffett (not suspect of beign anti-corporate-tax … although he should):
“When you are told that all repurchases are harmful to shareholders or to the country, or
particularly beneficial to CEOs, you are listening to either an economic illiterate or a
silver-tongued demagogue (characters that are not mutually exclusive).”
I am wondering which of this two things Bernie Sanders is likely to be. Although, maybe, Buffett’s last words are particularly well suited to Mr Sanders’ case
Mar 12 2023 at 2:29pm
I think you both need to be reminded that a reduction in supply increases the price.
Mar 12 2023 at 2:47pm
I am more than willing to learn from you about supply and demand as I always do from your comments.
But here, you are assuming that supply and demand is what drives the price of shares.
That may or may not be true, but you can not assume this and EMH at the same time, since, in this case, you would be assuming that a reduction of shares increase the value of the company “independently” of what happens to its intrinsic value.
And you are assuming that the value of the intrisic value of the company increases in a buyback since the initial intinsic value is X and the final value would be 0.2 X (that goes from the company to the leaving shareholders) + something bigger than 0.80 X due to the fact that the remaining shares increase their value JUST because there are less of them
Mar 12 2023 at 2:48pm
… and it should be obvious that “having less of them” does not change the intrinsic value of the company
Mar 13 2023 at 3:09am
Jon, what you’re missing is that, when a company buys back some of its stock, it must use some of its cash to do so. Cash is an asset of the firm. When the company has less cash, then its market cap decreases. So, while stock buybacks decrease the number of shares outstanding, they also decrease the market cap of the firm.
Mar 14 2023 at 3:55pm
If the company is buying back shares … the value of the company is not changing, and the number of shares outstanding is falling, then the value per share (ie the price) necessarily rises.
Ahem, *cough*… neat financial trick there!
I think you both need to be reminded that a reduction in supply increases the price.
And yet shares are not commodities. Question:
Roku, er, CleverCorp derives 25% of its market value from cash in an account at SVB. After that cash is suddenly feared lost, and saved only by Fed bailout, CC’s startled shareowners demand that it distribute all the cash to them so they can lose it for themselves, in ways they individually prefer, maximizing their personal utility.
CC agrees to do this, thus reducing its value as an entity by 25%. If it does so through a dividend, leaving its number of outstanding shares unchanged, how will its the price per share change? If it does so through a stock buyback, redeeming 25% of its shares so 25% fewer will be left outstanding, how will its per share price change?
Bonus question: How can CC distribute to its shareholders the cash comprising 25% of its market value without reducing its market value? It wants to know.
Mar 12 2023 at 9:49pm
The shares don’t magically disappear when a company buys them, just like the stocks don’t disappear when I purchase a stock and hold it. It’s just an ownership transfer.
The total market cap (which is what you seem to be referencing) is still the price per share times number of shares. It’s just that after a stock buyback, the company owns more of the shares than before the stock buyback.
Mar 12 2023 at 10:45pm
Not sure who you are answering to but frequently after beign repurchased by the issuer the shares are “canceled”. After that they have no market value and no longer represent a share of ownership in the issuing corporation.
So, you could say that yes, they “magically dissapear” (although there is nothing particularly “magical”, as in “exciting”, in the boring, and extensive, accounting rules that regulate this disappearance)
Mar 16 2023 at 11:03am
Thanks for the clarification
Mar 13 2023 at 3:27am
Vince, you are correct if everyone is rational, including company management. In your example, the company buys back $5k of stock, its cash goes down by $5k, so its market cap drops by $5k. Indeed, the drop in market cap exactly offsets the decrease in shares outstanding, resulting in no net change in stock price.
However, suppose the company doesn’t have any good investment prospects. If the company doesn’t do a stock buyback, it should just leave the $5k in cash instead of investing it in unprofitable investments. If the market, however, believes that the company will invest it in poor investments, then it will actually value that part of the company at less than $5k. So, if the company does buyback $5k of stock, then the market cap will actually drop by less than $5k. In that case, stock price can rise as a result of the buyback. Effectively, the buyback prevents management from investing the cash poorly.
When companies don’t have any good investment prospects for unused cash, leaving the cash uninvested is better than investing it poorly. However, having a lot of unused cash sitting around seems wasteful, which is why companies will return the cash to shareholders through a buyback. Buybacks are similar to dividends but (I believe) receive different tax treatment.
Mar 13 2023 at 11:56am
However, having a lot of unused cash sitting around seems wasteful
Explain this carefully to SVB shareholders … or to the airline / cruise line / cinema chains shareholders in 2020
Knowing at what point cash starts to be “wasteful” is kind of tricky, isn’t it?
Besides, most companies doing buybacks have a net debt position. So, it is more kind of a “wasteful (little) leveraged” debate … even trickier, and everchanging.
Mar 13 2023 at 12:31pm
We can add all kinds of “what ifs” to complicate the simple example. In your example, the market should have valued the extra $5000 at whatever it believed the company would do with the money, whether it were invested poorly, returned to shareholders, or something else.
Mar 13 2023 at 1:18pm
It is even more complicated (more “what-if”) than that since the market valuation of this $5,000 (or of the whole company operation to be precisse) does not depend only on the expected return of the investment opportunities of the company, but on the investment return on all the “similar” (on a risk-adjusted basis) investment opportunities in the world in all available sectors.
The main question in the expressions “good investment” or “poorly invested” is, relative to what?
Mar 13 2023 at 7:02pm
Vince, I was just trying to explain why, while your theoretical argument for why buybacks shouldn’t affect stock price is correct, there might be some empirical evidence out there that stock buybacks do increase stock price in practice. I actually don’t know whether the bulk of empirical data suggests that buybacks increase stock price or not.
Theoretically, neither stock buybacks, dividends, nor stock splits are supposed to affect shareholder total returns (Modigliani and Miller). However, some people seem to think that, empirically, there is some evidence that some or all of these do boost returns for signaling or other similar reasons.
I agree that it’s frustrating to hear poorly reasoned claims that buybacks boost stock prices by reducing the number of shares outstanding, which neglects the drop in market cap from the drop in cash holdings required to fund the stock buybacks.
Knut P. Heen
Mar 13 2023 at 12:42pm
Correct if the information is symmetric. It is very similar to a dividend (often taxed differently though). Buy backs may however signal positive information from the insiders. They would not buy back if the stock was over-priced now, would they? They would perhaps buy back if the stock was under-priced now. This asymmetry leads to a somewhat positive stock price reaction to buy backs. The market learns that the stock is not over-priced now.
Sanders is, of course, courting voters who are financial illiterates. He probably sounds smart to his voters.
Mar 12 2023 at 1:51pm
Of course, with fewer stocks, the value per share is higher
Why is so? this requires to forget that the company is using part of its value to buyback the shares.
Assuming the company is valued at its fair value and that investors are rational (nothing can really be said if you don’t assume this two premises) stock buybacks should be neutral to the stock value.
If a company buys some of its shares and retire the stock (if it doesn’t retire the stock nothing really changes, just the nominal owner of some of the shares), the value of the company should decrease in the amount of the retired shares. The number of outstanding shares is reduced so its price should be the same.
Imagine that the company has:
a) Operations with an expected NPV of 80 million dollar.
b) Non-operating cash with a 20 million dollar value
[That means the value of the company is 100 million dollar, if fairly valued]
c) 100 million outstanding shares with a value of $1 each
Now the company buybacks 20 million shares at $1 (the buying activity doesn’t not change the intrinsic value of the company so it should not change the value of shares) using its cash, and retire these 20 million shares. Now the company has:
a) Operations with an expected NPV of 80 million dollars
b) Zero dollars of non-operating cash.
c) 80 million of outstanding shares
The value of the outstanding shares (assuming the initial premises) should still be $1
The share buybacks are the equivalent (leaving apart tax considerations) to:
a) Paying a dividend equivalent to the cash used in the buyback (20 millions in the previous example). This should reduce the value of shares in 20 / x (with x being the outstanding shares in millions)
b) Some of the shareholders (80% of them) using this dividend to buy the shares of the other 20% (at the reduced value). This should be neutral to the value of the shares
c) The company doing a reverse split and reducing the number of outstanding shares by 1.25 which should increase the value of the remaining shares but just to compensate the reduction in value observed in a
The effect on the share price of a + b + c should be neutral
Mar 12 2023 at 5:27pm
Lacking investment opportunities, a company has to do stock buybacks to maintain its capital structure, otherwise, it begins to deleverage and with that its return on equity falls.
Assume a company with a 30% equity ratio.
Assets = Liabilities + Equity
100 = 70 + 30
Leverage ratio = Assets/Equity = 100/30 = 3.333
Now add a dollar of retained earnings to the balance sheet and note how the leverage ratio falls.
101 = 70 + 31
Leverage ratio = 101/31 = 3.258
Normally, a company with investment opportunities would add debt at the debt/equity ratio to maintain its capital structure. In the example given, it would borrow 2.33 against that dollar of retained earnings, i.e., 1 * 70/30. The new capital structure would be.
103.33 = 72.33 + 31
Leverage ratio = 103.33/31 = 3.333
Mar 12 2023 at 5:50pm
Not really. Buying back shares IS, in itself just an investment opportunity. From this perspective there is no difference between Company A buying shares of Company A as an investment opportunity and Company B buying shares of Company B as an investment opportunity.
And the “capital structure” can be maintain just buy paying out a dividend (in your example $1), no buybacks are required.
to maintain its capital structure, otherwise, it begins to deleverage and with that its return on equity falls.
And what if the return on equity falls? leveraged does not affect the intrisic value of a company. The lower return on equity due to a reduced level of leverage means a lower discount rate should be used to work out the NPV of said “return on equity”.
After all, this “lower return” due to a “lower leveraged” also has “lower risk” and so, has to be discounted at a lower rate of discount. At least if you are valuing companies using CAPM. Under this framework, the only effect of debt (leverage) on the value of the company equals the NPV of the future tax shield the additional debt provides.
Mar 12 2023 at 7:21pm
Most of modern finance is nonsense. It uses volatility as a risk surrogate and build up its models based on that. True risk is the chance of losing your capital. Note that volatility is never a concern for value investors.
Mar 12 2023 at 8:00pm
Most of modern finance is nonsense
If by “modern finance” you mean “what modern people living out of “finance” talk, write or tell investors/clients in order to make a living out of the investor’s money” then I could not agree more. This is total and utterly nonsense.
Warren Buffett is not using CAPM to value assets (and rightly doing so), if he were using CAPM, the ex-ante expected volatility of the expected returns should influence the discount rate used to calculate the NPV of these very same expected returns: the more volatile the returns (higher risk), the higher the discount rate.
Mar 12 2023 at 6:14pm
The only claim that could be made is that it is always in the benefit of “society” (whatever that means) to increase the installed capacity in a given area of the economy.
So, when Company A invest in buying Company A shares instead of investing in expanding the installed capacity on the sector in which Company A operates, this is harmful to “society”.
That basically means that society is always better served building “overcapacity” in every sector of activity. This is very unlikely to be true.
What the demagogues of all parties are failing to see is that the “money” that is “leaving” the area of activity of Company A can now be invested in the activity that creates the best return to society.
The Corollary of this is that for society Company A buying back its shares is better not only if Company A can’t not find a better opportunity investing in expanding capacity in ITS activity but if Company A can’t not find a better opportunity investing in expanding capacity in ANY area of activity.
Since investors are much better positioned than Company A management to evaluate the value created by investing on different areas of activity, shares buybacks are, for the most part, creating value to “society”.
[Fortunately, and to complicate things totally out of Sander’s understanding capacity, all this effects are “frictional”, since “ideal investors” are already “pricing” the value of company A investing in expanding capacity, taking into account the value that can be created investing in the most rewarding areas of activity with similar risk]
Thomas Lee Hutcheson
Mar 12 2023 at 10:30pm
Stock buybacks are just another way to to return dividends that becasue o quirks in the tax law are not treated the same as explicit dividends.
If we had a progressive on personal consumption tax and no tax on “business” income (which is just the income to the owners of the business), this nonsense would o away.
Mar 13 2023 at 8:10am
Stock buybacks are just another way to to return dividends
Not at all.
This “dividend” as you call it is paid just to some people that, after this payment, are no longer shareholders of the company (or reduce their position in it). The rest of the shareholders get nothing.
So the difference with a dividend is pretty significative. Particularly to the shareholders getting nothing in a share buyback (which are most of them).
are not treated the same as explicit dividends.
Because share buybacks have nothing to do with explicit dividends. It is like saying that capital gains and dividends are not treated the same. Nothing fishy there
In any case, the ex-shareholder (or “partially ex-shareholders”) will pay the capital gains tax associated with their sale of shares. This, very likely, will result in a higher taking to the US treasury.
Mar 13 2023 at 10:16am
Stock buybacks are just another way … of investing in an M&A operation. Instead of buying shares of Company B, Company A is buying shares of Company A
And it has the same tax treatment that any other M&A operation, why should it differ?
Mar 13 2023 at 10:37am
In practice it looks as though buybacks push up stock prices. This could be in the best interests of the company but is could also not be in the best interests of the company and actually harmful, but instead be good for the stock values of management.
Mar 13 2023 at 11:32am
What I find remarkable about this exchange is an almost total lack of recognition of empirical evidence on market reaction to share repurchases. Mechanical calculations and speculations about shares being undervalued or overvalued are not a substitute for looking at empirical studies on the effects of repurchases. There is a literature on this subject. A forthcoming paper in Financial Management provides recent evidence and reviews the literature. It is available at SSRN-id4149796. I copy the abstract below.
Abstract Share Repurchases………..forthcoming Financial Mgt
Using a large sample of US stocks covering more than three decades, we empirically examine common criticisms of and rationales for stock repurchases. Repurchases account for a tiny fraction of the trading volume in a typical stock, making their price impact too small to generate short-term price manipulation. Price appreciation following repurchases is modest and does not reverse on average, suggesting the small price increases following repurchases signal firms’ good prospects. Also, we find no evidence that CEOs of repurchasing firms are paid excessively or that repurchases crowd out valuable investment opportunities. Because repurchases do not appear to be systematically abusive, enforcement action should be sufficient to deal with any bad actors, and significant regulation seems unwarranted.
Mar 14 2023 at 3:26am
One of the reasons stock repurchases don’t have a huge effect on market prices is because this statement is not (entirely) true:
“Companies generally only consider engaging in stock buybacks when they have exhausted their investment opportunities and met their other obligations, meaning it is residual cash flow that is used for buybacks.”
This is too simplistic and a rather idealistic statement. It is one reason, but not the only one. First, a significant portion of stock (re)purchases are used to fund employee stock option plans. When an employee exercises a stock option, the employer has two options (!) to fund it: First, it can issue new shares; however, this has the effect of increasing the number of outstanding shares and diluting the EPS going forward. Second, it can purchase shares in the open market and deliver those shares to the employee, which generally turns around and does a “same day sale” of those same shares. This has no effect on the number of outstanding shares.
Also, managers use stock repurchases to manage earnings per share which is a metric followed by many market analysts. Paying a cash dividend and using the same amount to buy back own shares don’t have the same effect on EPS *going forward*.
One should focus on the *net* difference in the number of shares outstanding of a company during a particular time period and not solely on the number of own shares they buy in the open market.
Mar 14 2023 at 3:25pm
The empirical evidence is very relevant. But it has his “place”.
First you need a theoretical model, them the model is used to make a prediction and then the empirical analysis finds whether the data fit the model prediction or not.
So the empirical analysis can be used to support the model or to cast doubts or even to fully falsify it
Looking forward to read your paper, but, within this framework, it seems that your findings tend to validate the theoretical model (which is a relief since it has enough “holes” already).
Price appreciation following repurchases is modest and does not reverse on average, suggesting the small price increases following repurchases signal firms’ good prospects.
Wondering how you control for the momentum effect since stock buybacks tend to happen more often in bull markets.
Mar 14 2023 at 8:45am
I suspect that, in the aggregate, stock buybacks also help insure that the mean earnings yields for major indexes, for example, converge with mean NGDP growth rates, after periods of macro disequilibrium.