When a corporation announces a buyback -- the repurchase of stock shares from its investors -- its stock usually rises in price. Sometimes the stock rises because the buyback raises the value of the remaining stock. At other times, the announcement triggers changes in investor sentiment only indirectly related to underlying value.
Earnings Per Share
You own one share of Widget Corporation, which has 10 shares outstanding and current earnings of $100, or $10 per share. Widget announces a buyback of half the shares. With only five shares outstanding, and current earnings still $100, earnings per share now equal $20 -- the earnings per share have doubled. While it may be that nothing else has changed, the stock price rises because analysts and investors view companies with higher earnings per share more favorably.
Interest vs. Dividends
Another reason a buyback may increase share prices has to do with corporate taxes. If Widget pays shareholders a $0.50 per share annual dividend before the buyback, Widget is disbursing $5 annually, with no tax benefits to show for it -- dividends reduce capital but are not a tax-deductible expense. However, if the company borrows money to buy back the shares, the interest on the $5 loan is tax deductible, and the dividend payments are reduced by half. Even when the company uses its own money to buy back the shares, a McKinsey study shows, share prices will rise in response to the change in capital structure because the interest on money in its cash reserves, being taxable, "puts investors at a disadvantage."
Buybacks often tend to increase shareholder value for reasons having more to do with investor perception than with corporate realities. Think of Widget as just another investor; investors buy stocks they think will rise in value. When Widget buys back its own stock, it sends investors a signal that the company thinks its stock is currently undervalued and that share prices will rise. Investors respond favorably, and the share prices rise.
Shares often rise when a cash-rich company announces a buyback, the McKinsey study shows, because investors are relieved. Companies with large cash reserves may feel pressured to buy other companies or widen the scope of their operations. When the highly successful Widget Corp. uses its large cash reserves to buy its own stock, shareholders bid up share prices in relief, both because Widget is investing in an outperforming company, and because it is now less likely to use the remaining reserves to invest in less successful companies or to expand its operations into fields where it has no record of success. The McKinsey study shows that company shares rise on average from 2 to 3 percent upon the announcement of small buybacks, and 16 percent for large buybacks of more than 15 percent of the outstanding shares.
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