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Love your example, but to throw this aspect in, the market doesn’t always “value” companies the same way. Therefore, in your above example if the shares were a

Love your example, but to throw this aspect in, the market doesn’t always “value” companies the same way. Therefore, in your above example if the shares were actually being sold at $2 each, then the company is doing a disservice to the investors by buying the stock back. However, if the stock is under pressure (below its “fair” price), say 50 cents in the above example, then by buying the stock back, you are creating true value for your investors. Problem of course is that rarely do people running the company think this way.

scotty79 7y ago
> However, if the stock is under pressure (below its “fair” price), say 50 cents in the above example, then by buying the stock back, you are creating true value for your investors. Which means that your company just gambles its money at the stock market by betting on its own price.
hollerith 7y ago
harryh's argument can be modified to work regardless of how the market is valuing the company. Cash is easy for accountants to measure. Some other assets, such as the reputation of the company's products, are hard to measure even when they account for most of the company's market value (as in the case of Apple, Inc, whose stock price is currently about 9 times higher than its book value). So assume there is $100 of easily-measured cash. Don't consider the other assets; don't try to measure them; don't pay any attention to the attempts of the accountants to measure them (i.e., don't pay any attention to the company's book value). Assume the market values the company at $200. I.e., the company's market capitalization (stock price times shares issued) is $200. The argument continues by assuming or pointing out that investors are rational and that the SEC and the financial-accounting profession operate to give investors accurate information about how much cash the company has, so the market will value the company after the buy back at around $100. One reason an investor might buy shares is to try to take over the company, i.e., end up with all of its shares. Well, it is well known that the people executing a takeover often depend on getting access to the target's cash and other easily-measured (and consequently easily-sold) assets to help pay for the takeover. Specifically, if the company has $100 in cash, the takeover artist can afford to pay approximately $100 more for the company than if it has $0 in cash. (Specifically, if the target has $100 in cash, the takeover artist can go to one of his friends and says, "Loan me $100 and I'll pay you back with the cash held by the company I am planning on buying.) So since market cap is approximately what it would cost to buy the whole company, it makes sense that a reduction in cash would cause a reduction in market cap of approximately the same amount. Note that even investors who would never contemplate taking over a company can profit by selling their shares to someone who would and does, so they have the same incentive for valuing the company's cash as the takeover artist does: namely, the takeover artist can afford pay more for a company with cash, so the price paid by the takeover artist to the investor will be commensurately higher. Now the fact that management decided to buy the company's shares rather than deploy the cash in some other way does send a signal to the market that management believes the company's stock is good value with the result that the price might end up at $103 instead of $100. We might call that a "second-order effect" of the buyback. Another second-order effect is that fact that if the market knows a buyback is in progess, they'll tend to hold out for a higher price. (In other words, a big purchase tends to drive up the price; the company will spread the buying out over time to try to limit that effect.) But these second-order effect are limited in magnitude; they are very unlikely to cause the price to end up at, e.g., $200.

scotty79 7y ago

> However, if the stock is under pressure (below its “fair” price), say 50 cents in the above example, then by buying the stock back, you are creating true value for your investors. Which means that your company just gambles its money at the stock market by betting on its own price.

hollerith 7y ago

harryh's argument can be modified to work regardless of how the market is valuing the company. Cash is easy for accountants to measure. Some other assets, such as the reputation of the company's products, are hard to measure even when they account for most of the company's market value (as in the case of Apple, Inc, whose stock price is currently about 9 times higher than its book value). So assume there is $100 of easily-measured cash. Don't consider the other assets; don't try to measure them; don't pay any attention to the attempts of the accountants to measure them (i.e., don't pay any attention to the company's book value). Assume the market values the company at $200. I.e., the company's market capitalization (stock price times shares issued) is $200. The argument continues by assuming or pointing out that investors are rational and that the SEC and the financial-accounting profession operate to give investors accurate information about how much cash the company has, so the market will value the company after the buy back at around $100. One reason an investor might buy shares is to try to take over the company, i.e., end up with all of its shares. Well, it is well known that the people executing a takeover often depend on getting access to the target's cash and other easily-measured (and consequently easily-sold) assets to help pay for the takeover. Specifically, if the company has $100 in cash, the takeover artist can afford to pay approximately $100 more for the company than if it has $0 in cash. (Specifically, if the target has $100 in cash, the takeover artist can go to one of his friends and says, "Loan me $100 and I'll pay you back with the cash held by the company I am planning on buying.) So since market cap is approximately what it would cost to buy the whole company, it makes sense that a reduction in cash would cause a reduction in market cap of approximately the same amount. Note that even investors who would never contemplate taking over a company can profit by selling their shares to someone who would and does, so they have the same incentive for valuing the company's cash as the takeover artist does: namely, the takeover artist can afford pay more for a company with cash, so the price paid by the takeover artist to the investor will be commensurately higher. Now the fact that management decided to buy the company's shares rather than deploy the cash in some other way does send a signal to the market that management believes the company's stock is good value with the result that the price might end up at $103 instead of $100. We might call that a "second-order effect" of the buyback. Another second-order effect is that fact that if the market knows a buyback is in progess, they'll tend to hold out for a higher price. (In other words, a big purchase tends to drive up the price; the company will spread the buying out over time to try to limit that effect.) But these second-order effect are limited in magnitude; they are very unlikely to cause the price to end up at, e.g., $200.