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Remember, in a perfectly liquid market without taxes, a company which executes a share buyback will have no change in its stock price, since the shared redeemed

Remember, in a perfectly liquid market without taxes, a company which executes a share buyback will have no change in its stock price, since the shared redeemed will be exactly balanced by a reduction in the value of the company; and this is also exactly equivalent to distributing profits in the form of a dividend. On the other hand, when the rate of taxation on capital gains is lower than the rate of taxation on corporate dividends, it's advantageous to pay out surplus cash in the form of capital gains by executing a share buyback. This also provides a tax-planning benefit to shareholders: Everybody is forced to realize a dividend (and pay tax on it) but some shareholders will prefer to realize more or less capital gains in a given year. In Canada we have rules which sometimes reclassify capital gains as "deemed dividends" to prevent this sort of maneuver. A far better solution would be to simply fix the tax system so that economically equivalent actions get taxed identically in the first place.

howlingfantods 11y ago
Also, companies that borrow money to finance stock purchases (eg Apple) also save on their taxes because interest expense on debt is tax deductible.
- JDDunn9 11y ago
  Expensing interest only saves you the total interest x interest rate. So they just get a 35% discount on their interest rate.
  - howlingfantods 11y ago
    You're absolutely right that the savings on interest is post tax. However the tax deductibility of interest creates a substantial tax shield and in general, has a net positive value for the company since changing the capital structure by increasing debt decreases the weighted average cost of capital. Studies suggest that debt, because of the deductibility of interest, on average leads to ~1 dollar of additional company value for every 10 dollars of debt financing (vs equity financing).
  - sokoloff 11y ago
    Total interest * [marginal] tax rate, not times interest rate. (I give you credit for knowing the difference, but not every reader will know the difference, so I'm trying to help them, not nitpick you.)
JDDunn9 11y ago
> a company which executes a share buyback will have no change in its stock price... this is also exactly equivalent to distributing profits in the form of a dividend This is false (conditionally). Most valuations look something like: earnings x growth + cash. If you have cash that you cannot reinvest at the same ROI that you have been growing at, you can increase shareholder value by removing the cash element, since it's dead weight. A buy back is a way to invest that cash at the same ROI that your company is growing at. A dividend would require the investors to re-invest that cash and get the same ROI that the company is growing at. This is why it make sense for large, fast growing companies to buy back their shares and for large, slow-growing companies to issue dividends.
- knughit 11y ago
  Finance theory disagrees with you. A dividend lets the investors choose if they want to buy more shares (from the same sellers who would sell in a buyback) or mix their current shares with the cash.
  - JDDunn9 11y ago
    Investors buying more shares with dividends doesn't decrease the number of shares outstanding. If you increase the share price without decreasing the share count, you have created value out of thin air and are saying the company was more valuable without the cash than it was with it. The key is the asymmetry of information. The market price should reflect all public information. However the company has non-public information, which puts them in the best position to judge if money is best invested inside the company or out. Share buybacks are a legal form of insider-trading.
    - phyalow 11y ago
      Number of shares doesn't matter, enterprise value does and it doesn't change. Your implying that there would be a further equity issuance which doesn't routinely happen on buybacks.
      - 11y ago
baus 11y ago
I don't think this is accurate. When a company buys back shares, the shares are retired increasing the ownership percentage of the remaining shareholders. It is basically the opposite of issuing shares and diluting existing shareholders.
- knughit 11y ago
  What's not accurate?
- wlievens 11y ago
  Well in theory, if your shares are diluted /2 but the company's capital is x2, and all that capital is used efficiently, you have not lost anything either. Half slice of twice the pie.
  - baus 11y ago
    That makes sense. It is true the shareholders will own a bigger piece of a smaller pie.
- cecilpl 11y ago
  Right. The remaining shareholders own a larger percentage of a company that now owns less cash. Say the only thing my company owns is a bank account with $100 in it. There are 5 shares outstanding worth $20 each. The company buys back one share for $20, so now there are 4 shares outstanding in a company that owns $80.
  - djrogers 11y ago
    People don't invest in companies that merely have cash. Growth and recurring revenue are more important metrics to most
    - lyncnshare 11y ago
      It depends on the industry. Some stock valuations show that investors in certain industries like companies to hold on to cash reserves. This is especially true in the technology space where investors want companies to be able to cash in on the next big thing. Utilities, though, see their stock punished for holding onto excess cash.
hardcandy 11y ago
There's another issue created when companies issue debt in order to fund share repurchases. It may seem to make financial sense rates are so low but it's created a huge amount of additional leverage throughout the corporate world.
- eru 11y ago
  That's because interest payments on debt are taxed at a lower rate than dividends. Fix the tax system, and the leverage will go away.
deleted 11y ago
[deleted]
spectrum1234 11y ago
But none of this explains the main reason they would do this (a buyback or a dividend) instead of reinvest the profits. Yes the have lots of cash, but they have for awhile. So the interesting question is why are they doing this now given the medium/long term ROI a company with cash looks generate. It could mean they stopped seeing obvious medium/long term investments. Maybe a small bubble is 5-10 years away.
- cperciva 11y ago
  It's trivially true that not all companies can provide ROI surpassing the market average. The more interesting question to me is why they ever stopped.
- iofj 11y ago
  To see the answer to your specific question you need to look and compare these graphs: 1) https://ycharts.com/indicators/sp_500_eps https://ycharts.com/indicators/sp_500_eps (note: slowly rising, if you ignore seasonality) 2) https://ycharts.com/indicators/reports/sp_500_earnings https://ycharts.com/indicators/reports/sp_500_earnings (note: dropping fast) TLDR earnings are going down, but earnings/shares are going up. So what is going on ? Earnings for the US economy as a whole are dropping (pretty fast even). But the metric investors use to value shares, earnings per share is going up. That means U.S. companies are buying back shares at a faster rate than their earnings are dropping. Why ? Exactly to generate this outcome : normal valuation metrics for shares (net-present-value of future earnings per share) go up as a result of this operation. When cutting a million corners the share price of any (large cap) stock should be roughly NPV(8%, future_cashflow). The next question to ask is ... given that this uses a LOT of debt that is currently at very low interest rates, what happens if interest payments inevitably go up (either as a result of inflation, or of the FED raising rates) ? The problem with low interest rates is that, at the moment, 1% rate rise would quadruple interest payments for the government, and double interest payments for AA corporations.
  - hedonistbot 11y ago
    I might be wrong here but aren't most US companies flush with cash these days? I would assume that they use their cash reserves for the buybacks and not debt. Are there any stats on what is used to finance the buybacks?
lyncnshare 11y ago
I like this idea and my understanding is that they have a similar rule here in Germany.
jensen123 11y ago
Even if the tax percent was exactly the same on capitals gains and dividends, buybacks would still make sense. Dividends typically are paid out at least once year. On the other hand, you only incur capital gains when you sell shares. So, with share buybacks, you can potentially wait many years before you pay the tax, having the money accumulate for you in the meantime.
- Hhefferman1989 11y ago
  Don't forget the signaling effect, which can significantly boost share price
  - eru 11y ago
    Dividends also signal.
lakeeffect 11y ago
The calculation is (net income - preferred dividends/ weighted average common stock outstanding) = eps. Eps is on the income statement, face of financial statements and will go up if wacs goes down. Common stock out standing doesnt include treasury stock, stock repurchased by the company.
rsp1984 11y ago
and this is also exactly equivalent to distributing profits in the form of a dividend. I don't see this equivalence. I guess It's rather like settling debt since after a buy-back there will be fewer future dividends to pay. But nothing changes for continuing shareholders, does it?
- eru 11y ago
  For simplicity, assume that the company buys back stock from all shareholders equally, and then the shareholders trade amongst themselves. Dividends and buybacks are simply a way to get money from the company to the shareholder. The total number of outstanding shares is of no import---as you can see in stock splits.
- phamilton 11y ago
  Assume an investor takes all dividends and buys more shares. Example: Assume 10M shares at $1 each. With a 10 cent dividend ($1M total), an investor with 100k shares (1% of the company) receives $10k. The market cap drops to $9M (since cash holdings decreased) and the stock price drops to $0.90. They then buy ~11k (10k/.9) shares and have 111k shares, or 1.1%. Now instead assume the company does a buyback of 1M shares. Now there are 9M shares, each still priced at $1 (cash holdings decreased). The investor has 1.11% of the company. Lots of assumptions here (no fluctuation in price due to market reaction, cash is not discounted in market cap, etc) but the numbers check out in a perfect world. The point is that with a Dividend investors can choose whether to reinvest, whereas with a buyback everyone essentially reinvests.
  - rsp1984 11y ago
    Well but that just confirms my whole point. In a buyback the company invests its cash into stock instead of distributing it as dividend. It therefore makes an investment decision for the investor, who never gets to see any cash. The whole point of giving out dividends as a company is saying to an investor "here, you can invest this cash better than we can". If you're not giving out dividends you think you have better investment foresight than your investors, which may often be true. What you as a company then do then with the cash, whether you're investing it in R&D, personnel, etc.. or buy stock doesn't change the mathematics of things for the investor, even if the stock you buy happens to be your own stock.
eigenvalue 11y ago
This is not true. You are ignoring the most important factor of all, which is whether the company's share price is above or below its "intrinsic value". Of course, intrinsic value is a fundamentally fuzzy concept, but in some cases the share price is obviously out of line relative to historical measures of valuation (price to tangible book value, TEV/EBITDA, price to sales ratio, etc.). If there is no good fundamental reason for the lowered valuation (loss of patent protection, entrance of new competition, secular changes in technology, etc.), then it could create value for remaining shareholders if the number of shares is reduced and that capital is replaced with debt (or simply spending excess cash on the balance sheet). If the share price is above a conservative estimate of intrinsic value, then a company can easily destroy shareholder value by buying back shares. In that case, they might be better off issuing more shares or doing an acquisition for stock to take advantage of their overvalued currency. This sort of capital management is one of the most important ways a management team and board of directors can create value over time. For a good historical example, look at the case of Teledyne ( http://www.capitalideasonline.com/articles/index.php?id=2725 http://www.capitalideasonline.com/articles/index.php?id=2725 )
- Retric 11y ago
  Intrinsic value does not exist. Which is why we have markets in the first place. The obvious way to demonstrate this is you sell 10 shares for a higher price than 10 billion shares.
  - eigenvalue 11y ago
    It's true that intrinsic value is not usually well defined (except in simple cases, where a company is going to be liquidated and has clearly defined assets and liabilities that can be precisely measures, such as cash/marketable securities), but that doesn't mean that a thoughtful investor can't determine a reasonable range of likely values that errs on the side of conservatism. For example, by zero-valuing assets that are hard to quantify, such as an undeveloped plot of land. Or if there is an annuity-like cash flow stream from a long-term contract, one can discount those cash flows to the present using a conservative (high) discount rate. In cases where the share price is way below a conservative downside-case valuation, it's not necessary to know with precision what the intrinsic value might be.

howlingfantods 11y ago

Also, companies that borrow money to finance stock purchases (eg Apple) also save on their taxes because interest expense on debt is tax deductible.

JDDunn9 11y ago
Expensing interest only saves you the total interest x interest rate. So they just get a 35% discount on their interest rate.
- howlingfantods 11y ago
  You're absolutely right that the savings on interest is post tax. However the tax deductibility of interest creates a substantial tax shield and in general, has a net positive value for the company since changing the capital structure by increasing debt decreases the weighted average cost of capital. Studies suggest that debt, because of the deductibility of interest, on average leads to ~1 dollar of additional company value for every 10 dollars of debt financing (vs equity financing).
- sokoloff 11y ago
  Total interest * [marginal] tax rate, not times interest rate. (I give you credit for knowing the difference, but not every reader will know the difference, so I'm trying to help them, not nitpick you.)

JDDunn9 11y ago

> a company which executes a share buyback will have no change in its stock price... this is also exactly equivalent to distributing profits in the form of a dividend This is false (conditionally). Most valuations look something like: earnings x growth + cash. If you have cash that you cannot reinvest at the same ROI that you have been growing at, you can increase shareholder value by removing the cash element, since it's dead weight. A buy back is a way to invest that cash at the same ROI that your company is growing at. A dividend would require the investors to re-invest that cash and get the same ROI that the company is growing at. This is why it make sense for large, fast growing companies to buy back their shares and for large, slow-growing companies to issue dividends.

knughit 11y ago
Finance theory disagrees with you. A dividend lets the investors choose if they want to buy more shares (from the same sellers who would sell in a buyback) or mix their current shares with the cash.
- JDDunn9 11y ago
  Investors buying more shares with dividends doesn't decrease the number of shares outstanding. If you increase the share price without decreasing the share count, you have created value out of thin air and are saying the company was more valuable without the cash than it was with it. The key is the asymmetry of information. The market price should reflect all public information. However the company has non-public information, which puts them in the best position to judge if money is best invested inside the company or out. Share buybacks are a legal form of insider-trading.
  - phyalow 11y ago
    Number of shares doesn't matter, enterprise value does and it doesn't change. Your implying that there would be a further equity issuance which doesn't routinely happen on buybacks.
    - 11y ago

baus 11y ago

I don't think this is accurate. When a company buys back shares, the shares are retired increasing the ownership percentage of the remaining shareholders. It is basically the opposite of issuing shares and diluting existing shareholders.

knughit 11y ago
What's not accurate?
wlievens 11y ago
Well in theory, if your shares are diluted /2 but the company's capital is x2, and all that capital is used efficiently, you have not lost anything either. Half slice of twice the pie.
- baus 11y ago
  That makes sense. It is true the shareholders will own a bigger piece of a smaller pie.
cecilpl 11y ago
Right. The remaining shareholders own a larger percentage of a company that now owns less cash. Say the only thing my company owns is a bank account with $100 in it. There are 5 shares outstanding worth $20 each. The company buys back one share for $20, so now there are 4 shares outstanding in a company that owns $80.
- djrogers 11y ago
  People don't invest in companies that merely have cash. Growth and recurring revenue are more important metrics to most
  - lyncnshare 11y ago
    It depends on the industry. Some stock valuations show that investors in certain industries like companies to hold on to cash reserves. This is especially true in the technology space where investors want companies to be able to cash in on the next big thing. Utilities, though, see their stock punished for holding onto excess cash.

hardcandy 11y ago

There's another issue created when companies issue debt in order to fund share repurchases. It may seem to make financial sense rates are so low but it's created a huge amount of additional leverage throughout the corporate world.

eru 11y ago
That's because interest payments on debt are taxed at a lower rate than dividends. Fix the tax system, and the leverage will go away.

deleted 11y ago

[deleted]

spectrum1234 11y ago

But none of this explains the main reason they would do this (a buyback or a dividend) instead of reinvest the profits. Yes the have lots of cash, but they have for awhile. So the interesting question is why are they doing this now given the medium/long term ROI a company with cash looks generate. It could mean they stopped seeing obvious medium/long term investments. Maybe a small bubble is 5-10 years away.

cperciva 11y ago
It's trivially true that not all companies can provide ROI surpassing the market average. The more interesting question to me is why they ever stopped.
iofj 11y ago
To see the answer to your specific question you need to look and compare these graphs: 1) https://ycharts.com/indicators/sp_500_eps https://ycharts.com/indicators/sp_500_eps (note: slowly rising, if you ignore seasonality) 2) https://ycharts.com/indicators/reports/sp_500_earnings https://ycharts.com/indicators/reports/sp_500_earnings (note: dropping fast) TLDR earnings are going down, but earnings/shares are going up. So what is going on ? Earnings for the US economy as a whole are dropping (pretty fast even). But the metric investors use to value shares, earnings per share is going up. That means U.S. companies are buying back shares at a faster rate than their earnings are dropping. Why ? Exactly to generate this outcome : normal valuation metrics for shares (net-present-value of future earnings per share) go up as a result of this operation. When cutting a million corners the share price of any (large cap) stock should be roughly NPV(8%, future_cashflow). The next question to ask is ... given that this uses a LOT of debt that is currently at very low interest rates, what happens if interest payments inevitably go up (either as a result of inflation, or of the FED raising rates) ? The problem with low interest rates is that, at the moment, 1% rate rise would quadruple interest payments for the government, and double interest payments for AA corporations.
- hedonistbot 11y ago
  I might be wrong here but aren't most US companies flush with cash these days? I would assume that they use their cash reserves for the buybacks and not debt. Are there any stats on what is used to finance the buybacks?

lyncnshare 11y ago

I like this idea and my understanding is that they have a similar rule here in Germany.

jensen123 11y ago

Even if the tax percent was exactly the same on capitals gains and dividends, buybacks would still make sense. Dividends typically are paid out at least once year. On the other hand, you only incur capital gains when you sell shares. So, with share buybacks, you can potentially wait many years before you pay the tax, having the money accumulate for you in the meantime.

Hhefferman1989 11y ago
Don't forget the signaling effect, which can significantly boost share price
- eru 11y ago
  Dividends also signal.

lakeeffect 11y ago

The calculation is (net income - preferred dividends/ weighted average common stock outstanding) = eps. Eps is on the income statement, face of financial statements and will go up if wacs goes down. Common stock out standing doesnt include treasury stock, stock repurchased by the company.

rsp1984 11y ago

and this is also exactly equivalent to distributing profits in the form of a dividend. I don't see this equivalence. I guess It's rather like settling debt since after a buy-back there will be fewer future dividends to pay. But nothing changes for continuing shareholders, does it?

eru 11y ago
For simplicity, assume that the company buys back stock from all shareholders equally, and then the shareholders trade amongst themselves. Dividends and buybacks are simply a way to get money from the company to the shareholder. The total number of outstanding shares is of no import---as you can see in stock splits.
phamilton 11y ago
Assume an investor takes all dividends and buys more shares. Example: Assume 10M shares at $1 each. With a 10 cent dividend ($1M total), an investor with 100k shares (1% of the company) receives $10k. The market cap drops to $9M (since cash holdings decreased) and the stock price drops to $0.90. They then buy ~11k (10k/.9) shares and have 111k shares, or 1.1%. Now instead assume the company does a buyback of 1M shares. Now there are 9M shares, each still priced at $1 (cash holdings decreased). The investor has 1.11% of the company. Lots of assumptions here (no fluctuation in price due to market reaction, cash is not discounted in market cap, etc) but the numbers check out in a perfect world. The point is that with a Dividend investors can choose whether to reinvest, whereas with a buyback everyone essentially reinvests.
- rsp1984 11y ago
  Well but that just confirms my whole point. In a buyback the company invests its cash into stock instead of distributing it as dividend. It therefore makes an investment decision for the investor, who never gets to see any cash. The whole point of giving out dividends as a company is saying to an investor "here, you can invest this cash better than we can". If you're not giving out dividends you think you have better investment foresight than your investors, which may often be true. What you as a company then do then with the cash, whether you're investing it in R&D, personnel, etc.. or buy stock doesn't change the mathematics of things for the investor, even if the stock you buy happens to be your own stock.

eigenvalue 11y ago

This is not true. You are ignoring the most important factor of all, which is whether the company's share price is above or below its "intrinsic value". Of course, intrinsic value is a fundamentally fuzzy concept, but in some cases the share price is obviously out of line relative to historical measures of valuation (price to tangible book value, TEV/EBITDA, price to sales ratio, etc.). If there is no good fundamental reason for the lowered valuation (loss of patent protection, entrance of new competition, secular changes in technology, etc.), then it could create value for remaining shareholders if the number of shares is reduced and that capital is replaced with debt (or simply spending excess cash on the balance sheet). If the share price is above a conservative estimate of intrinsic value, then a company can easily destroy shareholder value by buying back shares. In that case, they might be better off issuing more shares or doing an acquisition for stock to take advantage of their overvalued currency. This sort of capital management is one of the most important ways a management team and board of directors can create value over time. For a good historical example, look at the case of Teledyne ( http://www.capitalideasonline.com/articles/index.php?id=2725 http://www.capitalideasonline.com/articles/index.php?id=2725 )

Retric 11y ago
Intrinsic value does not exist. Which is why we have markets in the first place. The obvious way to demonstrate this is you sell 10 shares for a higher price than 10 billion shares.
- eigenvalue 11y ago
  It's true that intrinsic value is not usually well defined (except in simple cases, where a company is going to be liquidated and has clearly defined assets and liabilities that can be precisely measures, such as cash/marketable securities), but that doesn't mean that a thoughtful investor can't determine a reasonable range of likely values that errs on the side of conservatism. For example, by zero-valuing assets that are hard to quantify, such as an undeveloped plot of land. Or if there is an annuity-like cash flow stream from a long-term contract, one can discount those cash flows to the present using a conservative (high) discount rate. In cases where the share price is way below a conservative downside-case valuation, it's not necessary to know with precision what the intrinsic value might be.