The Equity Buyback Puzzle

In the United States, corporations at nowadays create got the vogue to provide profits to shareholders via stock buybacks. The explanation that is unremarkably given is that this is for taxation efficiency. However, inwards this article I present that this complicates the valuation of equities. Once the expectation is that coin is returned via stock buybacks, in that location is no way of valuing the equity of the trouble solid without referencing the marketplace cost at which it is bought back. If administration destroys value with the buybacks, the fair value of the stock is lower. Additionally, it is necessary to contain the stock holder’s strategy into the valuation do – stockholders require to sell when administration is buying dorsum shares. This ambiguity of pricing reinforces Keynes’ declaration that equity pricing is a cast of beauty rival – but the judges that affair the most are inwards corporate management.

The nautical chart higher upwards shows the cyberspace amount of coin raised via issuing equities on the component division of nonfinancial corporations inwards the the States (according to the Flow of Funds) – it is heavily negative inwards recent decades. This negative value is the resultant of the fact that corporations are buying dorsum stock, too taking component division inwards cash takeovers. (An all-stock bargain would resultant inwards null cyberspace issuance of equities.) Corporate demeanour is different than it was inwards the 1960’s; the stock marketplace is no longer a rootage of funds for capitalism. It is at nowadays a house where corporate cash disappears.

Valuing Influenza A virus subtype H5N1 Doomed Company Paying Dividends

To start, nosotros volition value the equity of a firm that pays dividends. It has 1 ane one one thousand thousand shares outstanding. For simplicity, nosotros assume that the discount charge per unit of measurement is 0% (which sadly around recent involvement rates). We assume that:

• In twelvemonth 0 (now), it pays $1 ane one one thousand thousand inwards dividends.
• For every twelvemonth thereafter, in that location is a 50% gamble the companionship goes bankrupt, too all dividends cease. Otherwise, it pays a $1 ane one one thousand thousand dividend.

This agency that that in that location is a 50% gamble the owners volition have $1 ane one one thousand thousand inwards dividends ($1/share) immediately, too null else. If the companionship survives to pay a dividend inwards twelvemonth 1, in that location is a 50% gamble that volition live its final dividend ($2 per portion full payout).

It is left equally an do to the reader to create upwards one's hear that the expected value of the dividend payouts is $2 per share. (I.e., the probability-weighted average of full payouts possible is $2 per share.) We would say that $2 is the fair value of a portion using a dividend discount model, too that the fair value marketplace capitalisation of the trouble solid is $2 million. (Once again, shout out back that the discount charge per unit of measurement is 0%; the expected introduce value would live lower if nosotros discounted with a positive involvement rate.)

Additionally, since the description of the cash flows is fourth dimension invariant, the fair value volition ever live $2/share if nosotros repeat the valuation do at a futurity twelvemonth nether the status that the firm yet exists.

Valuation Using Buybacks

We at nowadays facial expression at what happens if the dividend payment is replaced with portion buybacks. Instead of paying cash to shareholders, the companionship wades into the marketplace too buys dorsum shares. What is the fair value of the company’s shares now?

The solely answer that appears to internally consistent to me is:

• We assume that the cost of shares at fourth dimension null must live $2/share. The buyback of $1 ane one one thousand thousand would purchase dorsum one-half of the shares – 500,000 shares.
• At Year 1, if the firm is yet a going concern, the novel cost must live $4/share. The marketplace capitalisation of the trouble solid remains at $2 million, but in that location are less shares. The $1 ane one one thousand thousand repurchase volition purchase dorsum 250,000 shares, or one-half the remaining shares.
• The procedure would repeat every twelvemonth a buyback occurs: the marketplace capitalisation remains at $2 ane one one thousand thousand (until default hits), but the release of shares outstanding is halved every year.

The strategy appears attractive from a taxation standpoint; the stock cost is rising, too then whatever shareholder profits volition live inwards the cast of upper-case missive of the alphabet gains.

What Happens If The Buybacks Occur At Different Prices?

I cannot come upwards up with a convincing fair value model if administration buys dorsum at a different cost than the trajectory I hand above. For example, if they pay equally good much (a real existent possibility), less than one-half of the shares are retired inwards the buyback. The people who sell instruct an excess profit, too the people who agree their shares lose value.

In the existent globe with uncertainty, buybacks away from fair value manifestly happens. However, such a possibility appears internally inconsistent inside an property cost model. Influenza A virus subtype H5N1 fair value model typically assumes that investors should live indifferent betwixt buying too selling at the fair price. An internally consistent model would tell yous that if administration pays equally good much, yous sell, too the analysis stops there.

Buy-And-Hold Conundrum

What I uncovering most puzzling near this instance is what happens to a buy-and-hold investor that starts with a relatively little holding.

In the instance of dividend payments, the expected value of the cash flows is $2 for a buy-and-hold investor (i.e., the fair value calculated above).

In the instance of the buybacks, it is almost sure enough (i.e., with probability 1) that the buy-and-hold investor volition live wiped out at some point. The expected value of the cash flows is $0. The companionship is worthless to such an investor.

Obviously, ane time an investor owns to a greater extent than than one-half of the shares outstanding, that investor has to participate inwards the buybacks if they occur at the fair value trajectory. But if the investor starts with a little holding, it is unlikely that the investor would goal upwards inwards that position.

It appears to me that inwards gild to value the stock, yous require to contain the selling strategy of the investor. The most consistent strategy is that all investors sell their stakes proportionally to the buyback. If nosotros ignore taxation consequences, this ends upwards existence equivalent to a dividend payment. Any departure from this strategy volition create winners too losers with equity holders.

Note that although my mortality statistics are high, this is non a special case. Since every companionship is but ane too-aggressive CEO away from bankruptcy, every companionship is ultimately doomed. If yous never sell your equities, the cash spent on buybacks is worthless to you.

Discussion

In improver to the taxation advantages of stock buybacks, supporters indicate out that dividends are quondam school. What matters is full return. Since a nifty bargain of equities are held inwards the cast of funds that reinvest dividends on behalf of investors, the coin would create got but been plowed dorsum into equities anyway.

However, buybacks correspond forced reinvestment into the participating corporations. On a portfolio basis, it is a forced reinvestment towards a exceptional type of firm – corporations that heavily purchase dorsum their shares. If portion buybacks are a score of companies with pathetic prospects, this is a suboptimal reinvestment rule. Additionally, if yous refer dorsum to the nautical chart at the pinnacle of this article, it appears that cyberspace issuance of equities is cyclical – shares were existence retired earlier too later on the recent crisis, when stock prices were at their highest. I produce non create got the information that distinguishes buybacks from takeovers, but my agreement is that buyback timing has been destroying value inwards aggregate.

Once nosotros realise that nosotros create got to contain the marketplace timing acumen of administration into the valuation of a stock, nosotros come upwards to the decision that equity valuation is inherently circular. For a minority shareholder, fair value is what mortal else is willing to pay for it – Keynes’ beauty contest.

Rather than looking at the corporate valuation from the standpoint of a minority shareholder – which is what safety discounted cash menstruum represents – nosotros create got to facial expression at the value of the trouble solid equally a business. And inwards particular, what is the value of command of the trouble solid to an acquirer. Suddenly, some of the weirder metrics used inwards valuation of technology scientific discipline companies brand to a greater extent than feel – value per engineer, etc.

Although this sounds to a greater extent than sophisticated too business-savvy, it is but equally circular inwards the electrical flow environment. In general, it is the same corporate managements that purchase dorsum their ain shares who also purchase out other companies. And it is unclear whether they are interested inwards valuing the shares they purchase properly. They are incentivised to force stock prices higher, courtesy of stock-linked compensation. And if they overpay? At the goal of the day, it’s non their money, it’s the shareholders’.

It appears that nosotros are dorsum where Keynes’ left us – it’s but a query of creature spirits. But, inwards the electrical flow environment, it’s the spirits inwards the C-suite offices that actually matter.

See Also

• This article past times Yves Smith - These Charts Show What Is Wrong With American Capitalism - discusses the macro context of portion buybacks inwards to a greater extent than detail.
• My comment on inflation too equities - Low Inflation, High Profits.

(c) Brian Romanchuk 2014