Recently, Dividend Growth Investor set out to determine whether stock buybacks benefit investors. The unsatisfying answer is that it depends. There is no computation that can be made today to determine whether a current stock buyback will be good for investors.
When a company buys its own stock, they are essentially retiring shares. This means that each remaining share represents a slightly higher percentage of the company, but the company has less cash. If the company is fairly valued, this should be a wash for investors.
However, if the company's stock is undervalued, the increased ownership of each share is a bargain and investors benefit. Conversely, if the company's stock is overvalued, the loss of cash from the share buyback is too great to compensate for the increased ownership represented by each share.
A problem here is that determining whether a stock is overvalued or undervalued depends on knowledge of the future. We can look back at a share buyback from 10 years ago and assess whether it was good for investors, but we can only guess whether today's share buyback will prove to be a good deal. At its core, arguing about the benefits of stock buybacks is the same as arguing about whether a given stock is a buy or a sell.
One thing we can tell from an announced stock buyback is that it is a signal by a company that they think their stock is undervalued. You'd think that if anyone had useful insight into this question, the company itself would. Unfortunately, companies have been accused of announcing a stock buyback to make investors think that the stock is undervalued. Investor reaction may then give the stock an artificial rise allowing insiders to cash in stock options for greater profits.
Another possible motivation for stock buybacks is to cover up share dilution due to issuing stock options to employees. Exercised stock options increase the share count and share buybacks decrease the share count. This can be a big problem for investors if the shares are overvalued, which would likely be the case if employees are exercising options in large numbers.
This is what I think most companies should do: buy back shares when issuing stock options. When I used to follow option grants, I noticed they would usually come at a bargain price. It's like the company would wait for a significant drop in the stock price before issuing options. This is great for the employees receiving the option grants, and a bad deal for the owners.
ReplyDeleteIf a company were required to retire the same number of shares at the same price as the option grant, it would really help offset the expense of the options, and keep said options from diluting existing shareholders.
@Gene: That's an interesting idea: retiring shares at the time of issuing options rather than when the options are exercised. Of course, this only works well for investors when the stock is undervalued. It's not uncommon for a company to issue stock options to rank and file employees when the stock price is very high. This excites the employees at virtually no cost. Retiring shares at the same time as duping employees would be bad for investors.
ReplyDeleteHere's a youtube clip on dividend policy presented by one of the most popular finance professors in the USA:
ReplyDeletehttp://www.youtube.com/watch?v=XAqjQvoPKuk&feature=feedf
The quality is poor, but it's interesting, and the end is funny.
Here's a youtube clip on dividend policy presented by one of the most popular finance professors in the USA:
ReplyDeletehttp://www.youtube.com/watch?v=XAqjQvoPKuk&feature=feedf
The quality is poor, but it's interesting, and the end is funny.
@Gene: That was definitely interesting an funny, but I disagree with his conclusion that stock buybacks became popular to avoid the future commitment of dividend increases. During the bull run in the 1980s and 1990s, investors undervalued cash in the bank. When companies bought their own stock, this increased the stock price. (Rationally, stock buybacks should have no effect on stock prices, but things were out of whack during the bull run.) Management with obscene numbers of stock options would do anything to increase stock prices and fatten their own wallets. So, they bought back stock.
ReplyDelete