What Investors Don’t Get About Buybacks

Shareholders trust the management teams of companies to make sensible use of the profits generated. Investing those profits wisely can greatly increase future profitability and, hence, shareholder return. Overpaying on an expansion project, for example, will do the opposite. Recently there has been increased focus on companies using their cash stacks to buy their own shares rather than looking for good ways to invest to grow. The question I am going to address is (and it’s an important one) is Does it matter at what price a company buys its own shares?

The intuitive answer, and one that many professional investors and commentators would give, is “of course, buying at a lower price is always better”. The reasoning is that companies that buy their stock before the price goes up get more bang for their buck than those that buy before it goes down. As a result, investors scold companies that buy at or near peak levels in their share prices (this article from Fortune is one of a very large number I found online).

But it actually does not matter. In fact, I can reverse the intuitive answer with two simple arguments:

(1) The shares the company buys get cancelled. The company is not investing in its own shares. Shareholders have no claim on the shares that are bought back and so do not gain or lose if this is done at a high or low price.

(2) When a company buys back its shares, it is buying them from shareholders. Shareholders always prefer to sell shares at a high price and therefore should thank any company that buys from them at such a lofty level.

Argument (1) is pretty solid but I think it’s worth digging into (2) in more detail. Shareholders as a group should prefer the “buy high” approach, but at the individual level those that sell to the company at the peak are better off (following a subsequent fall in price) than those who choose to hang on. That the latter group did not sell at the peak is not the fault of the company or in any way linked to a buyback or lack thereof.

Here’s another way to think about it: if companies had perfect foresight on their share price would they still buy back shares today if they knew the price would be lower in a week?

This is not just a theoretical exercise since companies do have inside information that can give them a sense of the short term trajectory of their share prices.

The answer, again, is that it does not matter. Neither the shareholders nor the company is better off if the buyback is delayed. The company can buy more with a fixed pot of cash if it waits, but the total value of equity following the buyback will be the same regardless of the timing.

However – and here’s where the intuitive answer starts to look (somewhat) good again – the share price will actually be slightly higher in the case when the company delays the buyback (let me know if you want proof of this). Any shareholder who would not sell regardless of when the buyback takes place is better off if the company waits a week. But, shareholders on average will not gain from this “buy low” strategy and, if the company does not buy at today’s higher price, shareholders miss out on the option of cashing in at a better price.

The discussion should not focus on whether timing buybacks in a certain way creates shareholder value (it does not), but how the decisions of individual shareholders to sell or not seem better or worse as a result of the timing. The actions that a subset of the shareholder base might take should not determine the way in which companies divvy out the spoils, so shareholders would be better off redirecting their attention to monitoring the use of the cash that actually stays in the company.


4 thoughts on “What Investors Don’t Get About Buybacks

  1. You’re right in terms of the cash on the balance sheet being reflected 1:1 in the market price. But Market price can matter with share buyback
    a) The effect on earnings per share is bigger the cheaper the stock price.
    b) If a company takes on debt (or buyback instead of paying of debt – doing WACC optimizing) doing a buyback at a high stock price is worse than doing at low stock price.

    Also note that tax rules and senior mgmt total comp linked to stock price and earnings per share, makes it rational for the CEO to
    1) buyback shares instead of paying dividend
    2) depending on when option and warrant mature do buybacks in the market even though profitable long term projects are available in the company

    • Thanks for the comment, miller1. On point (a) I think it’s useful to think about what it means for the stock to be cheap. Some people I’ve spoken to on this topic think about “cheap” to mean “below intrinsic value”. I don’t disagree with this way of looking at it (since my day job is to try to estimate intrinsic values), however, in this article I frame it in terms of whether the stock moves up or down after the company buys back the stock. I think this is a more general case since a stock can be “cheap” and just become “cheaper” (this characterization is especially apposite when you consider the finite horizon of most investors during which intrinsic value may never be reached).

      I’m not sure I agree with the argument in point (b). Perhaps you could elaborate on it. Finally, I do agree that tax and management incentives have a bearing on buybacks. The question of whether these factors distort the cost of capital is something I may explore in a future article.

      • a) think of cheap in terms of i.e. P/E values. Is the company buying back at P/E 10 (price is USD 50) or P/E 20(price is USD 100)? If the company buys back at 10x it(and shareholders) will get alot more bang for the buck in terms of increasing earnings per share. A future P/E expansion on the share price will then yield larger returns to shareholders.

        You are right, though, if one takes a very strict market efficiency view, that the market has valued the company at X P/E (stock price Y), which will then neither by cheap or expensive – just the correct value of the company at that given date. (In Nobel terms this will be Fama vs Schiller 😉 )

        The P/E example above is equivalent to your “intrinsic value”, I think the P/E example shows how it can matter also on a shorter horizon (look at the P/E expansion on the SP500 the last two years – or company specific cases which are more volatile – APPL, FB, etc)

        In these terms I think is interesting that Apple earlier this year chose to pay out dividends instead of buying back shares.

        b) It’s the summer of 2007. The Corporate finance advisors/consultant team has just left the office of the CEO of TransportCo. To optimize his capital structure (be WACC efficient) and maximize shareholder value, they have told him he needs to issue EUR 1bn and pay the money back to shareholders. Given his compensation contract, he of course chose to buy back shares. He buys them back at EUR 100 equivalent to approx a P/E 20x at the time. Fast forward to November 2008. TransportCo’s EBIT has collapsed and is in dire breach of their loan covenants, hence has to issue shares to. TransportCo’s issues at EUR 50 (P/E 5x at the time). [P/E contraction larger than share price decrease]. In this case the “old” owners of TransportCo has been significantly diluted, with very little upside from the initial share buy back.

        This can be viewed as a hindsight story (in 2007 the CEO cannot – and still cant – predict the future) – but the main point is to illustrate, that these capital structure exercise, with issuing debt can be harmfull in that it exposes the company to some longer term risks – which mean that shareholders today need to get a big benefit from the cash returned to them( bang for the buck) – either a high dividend yield (dividend large vs price) or alot of share bought back, which again implies it should be done when the company is “cheap”. Again, as mentioned above the view of market efficiency matters.

        Regarding tax and compensations packages vs paying dividends, I think it interesting from the point that there has been alot of (academic) debate about the increase in share buy back shows that western corps are running out of investments, and at the same time decries the reduction of dividends as proof that the earnings “quality is low”.(two arguments that actually counters each other a bit). My view is that share buy back are a natural mirror of decreasing dividends. Which again means that is quite natural for stock returns to come from capital gains (price appreciation) instead of dividends. And tax rules and TotalComp for senior mgmt makes it rational to focus on share buyback. And maybe focus to much! – what is the expected pay-off in 3Y from options/warrants and performace bonus linked to E/share from
        A) buying back shares with everything you got
        B) try to establish market presence in BRICs – investment heavy the first 3Y (at least)

      • Current (or estimated) P/E multiples do not predict future stock price movements so buying back stock at a “low” P/E does not mean the company is buying before the price goes up. I’m not a big supporter of Fama (see: https://expectingreturns.com/2013/06/16/informational-efficiency/), but I do think the market is efficient enough that a low P/E is not a reliable indicator of a bargain – a point you rightly acknowledge in your second paragraph. There is more to intrinsic value than P/E and even buying below an estimate of intrinsic value is not sufficient to create value for the remaining shareholders after a buyback.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s