What’s the Big Deal About Stock Buybacks?

When a company makes money, and in particular when a company has cash on hand (free cash flow) from its operations, there are a limited number of things that the company can and should do with that money.

They could make charitable contributions, and they could contribute to the communities in which they operate and they could find other ways to be good stewards for society, joining the fight for diversity and the health of the environment and it can pay its employees well, and contribute to their health and retirement, etc, and many companies do some of that, for the goodwill of the community, if not altruism.

But their main purpose, why they exist, why people own them (such as in their 401ks), is to make money.

And so the three main uses for their free cash are as follows: 

  1. Invest in the business to grow it
  2. Pay down debt, if they have it
  3. Return profits to shareholders

Companies do all of those things, but in particular, a lot of focus is put on the return of profits to shareholders because that is the real reason companies exist.

And there are two ways to do that

  1. Dividends
  2. Stock buybacks

Stock buybacks seem to be very political lately. I am a democrat. But I don’t agree with how this issue is framed, by democrats, as if it is a way to unfairly manipulate stock value, which, to me, demonstrates a lack of understanding. Or maybe some complain, not unreasonably, that it defers tax, because it can increase the value of the stock and that increase in net worth is not taxable until stockholders sell, while dividends are taxable immediately. But it also encourages some to sell (the company buys back from someone), and if they’ve held long enough to be in a gain position, that could accelerate tax. 

The real reason that corporations do this is because there are times when it is just a more efficient way to return money to shareholders than dividends.  When? When the company thinks the stock is undervalued.  Making that determination can be complicated, and subjective, based on factors such as the value of the assets, earnings, and growth potential. They could be wrong, but the management inside the company should know the company better than anyone. Assuming it is undervalued, buying back stock makes more economic sense than paying out dividends. Here is a simple, less subjective, example of why that’s true.

Assume that a company sells a million shares of stock for $1 a share.  Now the company is holding $1,000,000 in cash, and absent any expectation of earnings and growth, the shares should be worth $1 a share, because each share represents 1 millionth of a million dollars.  

But suppose for some reason the market doesn’t recognize that value and the market price is only .50 cents, meaning that if I wanted to sell my shares I can only find people willing to pay .50 cents for it. It doesn’t have to make sense. The market doesn’t always make sense. But let’s also assume that at some point in time, a time we’ll call “true worth,” all value will be recognized by the market and the stock will be at $1 per share.

If the company decided it didn’t need $1,000,000 and it wanted to return $500,000 to its shareholders, it could pay a dividend of .50 cents per share (technically if the company hasn’t made any money yet, that’s a return of capital, not a dividend, but nevermind that).  Now, after everyone gets their dividend, there are  1,000,000 shares and $500,000 cash in the corporation, so at true worth, each share will be worth .50 cents. Owners would have paid a dollar, got .50 cents back in cash, and still have stock worth .50 cents.  They haven’t made any money, they haven’t lost any money.

Let’s assume instead that the company took that same $500,000 and decided to buy back as much stock as it could at .50 cents a share, the undervalued market price, and give whatever is left as a dividend.  And let’s assume that shareholders were willing to sell 500,000 shares at that price, and the rest wanted to hold on.  So now the company spends $250,000 to buy back 500,000 shares. The owners that sold have lost money, but they didn’t believe in the company, and maybe they think they could have lost more, that was their choice. 

Those who remain are the ones who really believe in the company, and they now, collectively, own 500,000 shares of a company that has $750,000. At true worth, each share will be worth $1.50  If the remaining $250,000 is paid out as a dividend, they get .50 cents and then they still have stock worth $1 per share, because the company has $500,000 and there are 500,000 shares.  Either way they are 50% better off, and the company hasn’t even made any money, because it took advantage of being unappreciated when it returned value to shareholders.  

This doesn’t work if the shares are overvalued. If the company paid $2 a share to buyback shares, they’d end up with 750,000 shares outstanding with $500,000 and true value would be .75 cents a share, which would have rewarded those who sold, and punished the remaining shareholders, by pushing the true value down. That ultimately hurts shareholders including executives of the company that still hold shares (and most do – even though they might sell some from time to time).

Buying back shares when the stock is undervalued also helps the market recognize the true value, because it weeds out the owners that don’t see it, buying back, by mutual agreement, their shares, and leaving the owners who are committed, which in turn also protects against an opportunistic takeover from some big money source that recognizes the bargain. What if I noticed that I could buy a company that had $1,000,000 for $500,000? I could do that, screwing all the little guys who had this stock in their 401Ks and making $500,000 for myself. And then maybe I just raid the cash and fire all the employees. Is that what we want? 

Not this democrat.

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