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Buy-backs are more tax efficient because they increase stock price. Stock price increases are not taxed until they are realized, so it is beneficial to long-te

Buy-backs are more tax efficient because they increase stock price. Stock price increases are not taxed until they are realized, so it is beneficial to long-term stockholders who may not sell for many years, possibly not for decades. Dividends are taxed in the year of payment, so investors lose some of that gain within a year. On the flip side, buy-backs can be a poor way to spend cash, as companies might buy back at high stock prices. So the third way to reward the stockholder is to just keep that cash stashed in a bank account -- you get neither taxed (dividends) nor do you buy back potentially inflated shares. However, you have the cash stashed away to do either if you ever need to, or find a good opportunity to (e.g., stock price slump.)

portent 10y ago
Personally I don't understand why a buy-back should increase stock price. Sure, there are fewer shares - but the value of the company has gone down (it has less free cash, i.e. fewer assets) and the two effects should exactly offset each other.
- mgolawala 10y ago
  The value of the shares goes up because, even if the business and profitability stays exactly the same, with fewer out standing shares, the earnings per share goes up.
  - portent 10y ago
    Yeah but if you transfer an asset (cash) out of the company, all other things being equal, the value of the shares must go down. This McKinsey article is old but explores the topic in some detail. http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-value-of-share-buybacks http://www.mckinsey.com/business-functions/strategy-and-corp... -- "Sending signals The market responds to announcements of buybacks because they offer new information, often called a signal, about a company’s future and hence its share price. One well-known positive signal in a buyback is that management seems to believe that the stock is undervalued. Executives can enhance this effect by personally purchasing significant numbers of shares, since market participants see them as de facto insiders with privileged information about future earnings and growth prospects. A second positive signal is management’s confidence that the company doesn’t need the cash to cover future commitments such as interest payments and capital expenditures. But there is a third, negative, signal with a buyback: that the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere. Some managers are reluctant to launch buyback programs for this reason, but the capital market’s mostly positive reaction to such announcements indicates that this signal isn’t an issue in most cases. In fact, the strength of the market’s reaction implies that shareholders often realize that a company has more cash than it can invest long before its management does. Therefore, the overall positive response to a buyback may well result from investors being relieved that managers aren’t going to spend a company’s cash on inadvisable mergers and acquisitions or on projects with a negative net present value. In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what management will do with excess funds. Such shareholder skepticism would be well founded. In many industries, management teams have historically allocated cash reserves poorly. The oil industry since 1964 is one example (Exhibit 4): a huge price umbrella for much of this period, courtesy of the Organization of Petroleum Exporting Countries (OPEC), provided oil companies with relatively high margins. Nevertheless, for almost three decades the spread between ROIC and cost of capital for the industry as a whole was negative. Convinced that on a sustained basis the petroleum industry could not deliver a balanced source of income, many companies committed their excess cash to what turned out to be value-destroying acquisitions or other diversification strategies. For example, in the 1970s, Mobil bought retailer Montgomery Ward; Atlantic Richfield purchased Anaconda, a metal and mining company; and Exxon bought a majority stake in Vydec, a company specializing in office automation. All of these cash (or mostly cash) acquisitions resulted in significant losses."
    - SisypheanLife 10y ago
      This is all over simplified to show the point. Lets say you have a $100 stock with 100 shares outstanding. The company can issue a dividend of $5 to all 100 shares costing $500. This results in a $95 share price and $5 of realized gain for each share. The company could also buyback 5 shares at $100, also costing $500, and also increasing the share value. This is canceled though as the company loses approximately 5% of its value by spending that $500. The effect is that the share price is still worth $100, with each share now holding 5% more of the company than it did previously.
- xapata 10y ago
  Regardless, the person who sold shares to the company gets taxed at long-term capital gains rates instead of dividend rates. Much better. If Icahn started selling shares to someone else, the price would fall. If he sells to Apple itself, much less likely that the price would fall.
- danans 10y ago
  If demand for shares is constant during the buyback, then reducing the number of shares via a buyback should send the price up. Which raises the question: Why would marginal demand for shares be independent from cash holdings? Probably because the investors have other reasons for wanting the stock, chief among them being future growth potential.
- valuearb 10y ago
  One reason is embedded in the valuation, every stock is worth it's future cash flows, discounted for time. Since we can't know the future it's actually forecast future cash flows, and you discount that stomata for risk. A cash dividend eliminates the risk associated with that part of the value, increasing it. An example would be a stock you value at $10 per share. It has $5 per share of excess cash, but you attribute $3 of value to the cash. This is because you discount 20% for dividend taxes were it to be paid out, and a further 20% for risk it may never be dividended or that it might be invested poorly. So if the company pays out the actual $5, netting you $4, the remaining shares should still be worth $7 in your valuation estimate, meaning $1 in value is created. This is of course pedantic, because it can be argued that there should be no risk discount for cash, and if there is certainly not 20%. My argument would be I'd value $1 of cash in Buffett's hands as worth more than $1, and in the hands of many public CEOs hands at less than $1. There is too much self-dealing by public management, and they usually possess little investment expertise outside their own business. Does Apple have any car development expertise or unique IP? I'd say the risk of them blowing $40B in that market is significant. So I'd argue that a small risk discount exists in most cases and is recaptured upon dividend.
TuringNYC 10y ago
That is the strangest down-vote I've ever received on a textbook answer straight from Finance 101.
- portent 10y ago
  I think it's much more subtle point than buy-backs increase share price, otherwise it opens up some basic arbitrages. The point is, the share price already incorporates the value of the assets used for the buy-back, so buying back shares increases earnings per share but reduces asset values (and future earnings from leveraging those assets) and the two effects offset. Simple example: company A has 100 shares outstanding and only 1 asset: $100 The value of each share is $1. It then decides a share buy-back is a good strategy, and buys back 50 shares for $50. It now has 50 shares outstanding and $50 of assets. The value of each share is still $1. The buy-back has no effect on share price.
  - TuringNYC 10y ago
    The question was about why buybacks are more tax efficient -- the answer is open-and-shut -- because benefit realization with buybacks is pushed to time of sale (in many cases far in the future), which is more advantageous than dividends which get taxed in the same tax year. In any case -- to answer your question -- in your example, it would not have any effect on share price as it seems the company is just a holding company for $100. However, in the case of Apple they have other assets besides the cash (brand, intellectual property) and those assets produce more cash -- so all the cash the other assets generate in the future gets distributed to a smaller number of shareholders.
    - portent 10y ago
      On the point about taxation, if you have a choice between dividends or share appreciation, I agree with you that share value appreciation gives more flexibility to better manage tax liabilities. But you answered as a fact that a share buyback increases share price, and sorry but I don't agree with that point - as demonstrated, for an asset holding company it is not the case. And for a company with cash generation capabilities there is still a subtle point about whether the company can create more value with the cash than the shareholders; if the company can create more value than shareholders, then removing cash from the company via a share buyback should reduce share price. If it cannot, then removing cash from the company should increase the share price.

portent 10y ago

Personally I don't understand why a buy-back should increase stock price. Sure, there are fewer shares - but the value of the company has gone down (it has less free cash, i.e. fewer assets) and the two effects should exactly offset each other.

mgolawala 10y ago
The value of the shares goes up because, even if the business and profitability stays exactly the same, with fewer out standing shares, the earnings per share goes up.
- portent 10y ago
  Yeah but if you transfer an asset (cash) out of the company, all other things being equal, the value of the shares must go down. This McKinsey article is old but explores the topic in some detail. http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-value-of-share-buybacks http://www.mckinsey.com/business-functions/strategy-and-corp... -- "Sending signals The market responds to announcements of buybacks because they offer new information, often called a signal, about a company’s future and hence its share price. One well-known positive signal in a buyback is that management seems to believe that the stock is undervalued. Executives can enhance this effect by personally purchasing significant numbers of shares, since market participants see them as de facto insiders with privileged information about future earnings and growth prospects. A second positive signal is management’s confidence that the company doesn’t need the cash to cover future commitments such as interest payments and capital expenditures. But there is a third, negative, signal with a buyback: that the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere. Some managers are reluctant to launch buyback programs for this reason, but the capital market’s mostly positive reaction to such announcements indicates that this signal isn’t an issue in most cases. In fact, the strength of the market’s reaction implies that shareholders often realize that a company has more cash than it can invest long before its management does. Therefore, the overall positive response to a buyback may well result from investors being relieved that managers aren’t going to spend a company’s cash on inadvisable mergers and acquisitions or on projects with a negative net present value. In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what management will do with excess funds. Such shareholder skepticism would be well founded. In many industries, management teams have historically allocated cash reserves poorly. The oil industry since 1964 is one example (Exhibit 4): a huge price umbrella for much of this period, courtesy of the Organization of Petroleum Exporting Countries (OPEC), provided oil companies with relatively high margins. Nevertheless, for almost three decades the spread between ROIC and cost of capital for the industry as a whole was negative. Convinced that on a sustained basis the petroleum industry could not deliver a balanced source of income, many companies committed their excess cash to what turned out to be value-destroying acquisitions or other diversification strategies. For example, in the 1970s, Mobil bought retailer Montgomery Ward; Atlantic Richfield purchased Anaconda, a metal and mining company; and Exxon bought a majority stake in Vydec, a company specializing in office automation. All of these cash (or mostly cash) acquisitions resulted in significant losses."
  - SisypheanLife 10y ago
    This is all over simplified to show the point. Lets say you have a $100 stock with 100 shares outstanding. The company can issue a dividend of $5 to all 100 shares costing $500. This results in a $95 share price and $5 of realized gain for each share. The company could also buyback 5 shares at $100, also costing $500, and also increasing the share value. This is canceled though as the company loses approximately 5% of its value by spending that $500. The effect is that the share price is still worth $100, with each share now holding 5% more of the company than it did previously.
xapata 10y ago
Regardless, the person who sold shares to the company gets taxed at long-term capital gains rates instead of dividend rates. Much better. If Icahn started selling shares to someone else, the price would fall. If he sells to Apple itself, much less likely that the price would fall.
danans 10y ago
If demand for shares is constant during the buyback, then reducing the number of shares via a buyback should send the price up. Which raises the question: Why would marginal demand for shares be independent from cash holdings? Probably because the investors have other reasons for wanting the stock, chief among them being future growth potential.
valuearb 10y ago
One reason is embedded in the valuation, every stock is worth it's future cash flows, discounted for time. Since we can't know the future it's actually forecast future cash flows, and you discount that stomata for risk. A cash dividend eliminates the risk associated with that part of the value, increasing it. An example would be a stock you value at $10 per share. It has $5 per share of excess cash, but you attribute $3 of value to the cash. This is because you discount 20% for dividend taxes were it to be paid out, and a further 20% for risk it may never be dividended or that it might be invested poorly. So if the company pays out the actual $5, netting you $4, the remaining shares should still be worth $7 in your valuation estimate, meaning $1 in value is created. This is of course pedantic, because it can be argued that there should be no risk discount for cash, and if there is certainly not 20%. My argument would be I'd value $1 of cash in Buffett's hands as worth more than $1, and in the hands of many public CEOs hands at less than $1. There is too much self-dealing by public management, and they usually possess little investment expertise outside their own business. Does Apple have any car development expertise or unique IP? I'd say the risk of them blowing $40B in that market is significant. So I'd argue that a small risk discount exists in most cases and is recaptured upon dividend.

TuringNYC 10y ago

That is the strangest down-vote I've ever received on a textbook answer straight from Finance 101.

portent 10y ago
I think it's much more subtle point than buy-backs increase share price, otherwise it opens up some basic arbitrages. The point is, the share price already incorporates the value of the assets used for the buy-back, so buying back shares increases earnings per share but reduces asset values (and future earnings from leveraging those assets) and the two effects offset. Simple example: company A has 100 shares outstanding and only 1 asset: $100 The value of each share is $1. It then decides a share buy-back is a good strategy, and buys back 50 shares for $50. It now has 50 shares outstanding and $50 of assets. The value of each share is still $1. The buy-back has no effect on share price.
- TuringNYC 10y ago
  The question was about why buybacks are more tax efficient -- the answer is open-and-shut -- because benefit realization with buybacks is pushed to time of sale (in many cases far in the future), which is more advantageous than dividends which get taxed in the same tax year. In any case -- to answer your question -- in your example, it would not have any effect on share price as it seems the company is just a holding company for $100. However, in the case of Apple they have other assets besides the cash (brand, intellectual property) and those assets produce more cash -- so all the cash the other assets generate in the future gets distributed to a smaller number of shareholders.
  - portent 10y ago
    On the point about taxation, if you have a choice between dividends or share appreciation, I agree with you that share value appreciation gives more flexibility to better manage tax liabilities. But you answered as a fact that a share buyback increases share price, and sorry but I don't agree with that point - as demonstrated, for an asset holding company it is not the case. And for a company with cash generation capabilities there is still a subtle point about whether the company can create more value with the cash than the shareholders; if the company can create more value than shareholders, then removing cash from the company via a share buyback should reduce share price. If it cannot, then removing cash from the company should increase the share price.