5 ms·
If there are 100 shares of a company worth $1000 each - the company has a value of $1000/share * 100 shares = $100,000. The company has $10000 in after-tax pro
by rfrey 7y ago
If there are 100 shares of a company worth $1000 each - the company has a value of $1000/share * 100 shares = $100,000.
The company has $10000 in after-tax profit that it would like to distribute, and you own 1 share. Since the money will be gone, the company will be worth $100,000 - $10,000 = $90,000 after the distribution.
- The company could pay a $100 per share dividend. You would get a $100 dividend but have to pay (say) 15% tax, so you now have $85 cash plus 1/100 of the company ($900), so $985.
- OR the company could buy back 10 shares. Now each share is worth $90,000 / 90 shares, or $1000. You don't pay any tax, your share is worth the same, but now you have 1/90 of the company instead of 1/100, so a greater share of future earnings.
In real life, the value of future earnings dominates the price (well, hope and greed do, but whatevs) rather than the cash-on-hand. The price should immediately go up once the buyback is announced to reflect that existing shareholders will get a bigger piece of the pie. That increase is not taxed until they sell, and the shareholder comes out ahead for the same cash distribution by the company.
- gundmc 7y agoFantastic and intuitive explanation. Thank you for this!
- mav3rick 7y agoReally amazing explanation.
- simonebrunozzi 7y agoMan, I hope you do this for a living. You're amazing. Super clear explanation.
- milesward 7y agoI agree, he did great!
- jbay808 7y agoThis is a great explanation, but who would sell their share back to the company for $1000 if the value of the other shares will increase immediately after the buy-back? I assume that if it's expected the company shares will go up in value due to the buyback, then they will have to pay a premium and buy the shares at a price that is close to the post-buyback share value. So, perhaps at $1010/share. However, I think there's no premium price equal to the post-buyback share price that they can pay to buy back shares that doesn't result in the company total value increasing as a whole from the buyback. This seems to be a contradiction. I can only conclude that it isn't known that the buyback will raise share prices, because the loss of capital from the company should balance the increased fraction of future earnings that each share represents. (edit: rewrote post after working through its logic).
- manigandham 7y agoThe a logical equation assuming perfect rationality and an infinite timeline with a company that is only growing. Reality is clearly much more complex and there are thousands of reasons why someone would sell their shares.