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I have stock in a company that is buying back common stock through the market. I have some questions about this strategy.
1. Aren't shares repurchased using retained earnings?
2. If after repurchasing the stock the stock price doesn't go up, haven't the remaining stockholders lost value? For example, lower market to book ratio??
3. How do I compare shareholder value from one year to the next when shares are repurchased?
4. Generally speaking, what reasons are there for repurchasing stocks and how do I evaluate if they are effective?
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IMO buybacks of stock are a sign that management feels the stock is undervalued. Otherwise, they could do acquisitions, increases dividends or a special dividend. However, IMO, stock buybacks are not significant to shareholders unless it's greater than 2-3% of shares outstanding.
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One major factor regarding a company's decision to buy back stock is their investor clientel. If the investors are in higher tax brackets, they would prefer buy backs versus dividends for tax reasons (capital gains taxed at 20% versus 39.6%) and vice versa. Generally, investors prefer a stable policy--be it dividends or buy backs--versus one that fluctuates. If it fluctuates excessively, that generally lowers the price of a stock and increase the requried return.
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One major factor regarding a company's decision to buy back stock is their investor clientel. If the investors are in higher tax brackets, they would prefer buy backs versus dividends for tax reasons (capital gains taxed at 20% versus 39.6%) and vice versa. Generally, investors prefer a stable policy--be it dividends or buy backs--versus one that fluctuates. If it fluctuates excessively, that generally lowers the price of a stock and increase the requried return.

I agree with the simple logic at work here.

However, this sort of buyback program is likely to force the company to buy back shares at relatively high prices, seeming to run some risk of destabilizing the firm, or at least of undercutting the natural supports that might exist for the stock price without aggressive buy-backs.

After all, wouldn't it make at least as much sense to put the same capital to work at something that would generate future free cash flows, rather than bury present cash back into the firm, assuming that the firm is at or near fair value?

I realize there are many arguments against a dividend, including those you mentioned. But the long-term interest of investors who do not wish to be active traders would probably be better served in this situation by a dividend, even though the immediate tax consequences are worse, assuming that the company has no viable opportunities at hand for reinvesting those earnings in a way that makes sense for the company and the interests of shareholders.
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After a company takes care of its costs, I agree that using the retained earnings to invest in capital projects that create a return for investors greater than the cost of the capital is the correct thing to do.

If there are no projects of this nature in the offing, the company needs to get the money to the investors in one form or another so they can invest the funds themselves. I don't see how buying back stock would destabilize the firm. I can see it creating demand and raising the prices of existing stockholders (discounting other forces affecting stock prices) and putting cash in the pockets of those who sell their stock back to the company. BTW, by creating capital gains, not only is the tax rate lower, but the investor can control when taxes are paid on those gains, if ever. If the stock is passed on to heirs, the basis is raised to the existing fair market value, thus eliminating any taxes on the appreciation.

I understand there is definitely a place for dividends; a bird in the hand is worth two in the bush, particularly for those that rely on a set amount of money coming in at set intervals. On the other hand, for many who receive dividends, it suddendly creates a requirement to decide what to do with that money. So for many who receive dividends, a trade is occuring to reinvest that money.
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I understand there is definitely a place for dividends; a bird in the hand is worth two in the bush, particularly for those that rely on a set amount of money coming in at set intervals. On the other hand, for many who receive dividends, it suddendly creates a requirement to decide what to do with that money. So for many who receive dividends, a trade is occuring to reinvest that money.

Your last sentence, in particular, sparked the following for me:

Assuming one accepts efficient market theory (whether in weak or strong form) a company that consistently chooses to buy its own stock in lieu of dividends would in effect be choosing for its holders a sort of enforced DRIP.

That leaves holders with a choice, either of selling some fraction of holdings in response to the perception that the buy-back has lofted the share price to unsustainable levels, or to accept the action as equivalent to what the investor would have done with their retained fraction of the dividend (namely, invest it back into the company).

Either way, dividend or buy-back, the company is effectively distributing funds to shareholders, or at least trying to. In a buyback, investors must sell at least a fraction of holdings if they feel that their "dividends" would be better placed with a company that makes more prudent or more promising internal investments.

Given that a buyback is rarely materially productive for the company but more like a form of window dressing, it seems to me that such practices are likely to erode, over time, the faith investors are likely to have in management, and that is likely to lead, eventually, to a recognition that the firm is foregoing real opportunities in favor of financial engineering and balance sheet decorating.
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Hi ruful47,

My take on stock repurchases by the company are that they typically don't do much for stockholder value except for an occasional small jump in price on the announcement. Though now it seems that the announcements don't even do that much as the market has seen so many of these things, they tend to discount any long term positives.

More than likely, if anything, repurchases may rob a little shareholder value based on these common factors.

1. To get any significant value from a repurchase, the stock should be well undervalued. Company managements are probably not the best judges of their own firms value and will probably tend to repurchase at too high a price.

2. Many buybacks are just a way to get shares into the treasury to make them available for employee options without having to issue new shares.

3. Dollars spent on share repurchases, even in the best circumstance, are a one time benefit. The same dollars well reinvested in the company would have a compounded shareholder value return over time.

Regardless of these factors, in my opinion most repurchases are of such minor importance relative to company performance that I consider them only interesting facts when it comes to the valuation of the company.

ZB
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Given that a buyback is rarely materially productive for the company but more like a form of
window dressing, it seems to me that such practices are likely to erode, over time, the faith
investors are likely to have in management, and that is likely to lead, eventually, to a recognition that
the firm is foregoing real opportunities in favor of financial engineering and balance sheet decorating.


Well, yes, and, isn't it key to determine what will be done with the repurchased shares? If they are retired the shareholders benefit from having a bigger piece of the company. If they are used for ESOPs, there is obviously a much lower chance for benefit to shareholders. Additionally, it seems that I would have to revise downward any assumptions about ongoing growth if the best investment choice for excess cash was share buyback. It seems to indicate a slowing rate of growth/stable growth business with mgmt that doesn't aggressively seek increased value for owners.

Finally, share repurchase, whatever its "goodness or badness" still seems to be preferable to using the money to acquire marginal assets.

Some random thoughts from the Ozarks,

Bruce
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Given that a buyback is rarely materially productive for the company but more like a form of window dressing, it seems to me that such practices are likely to erode, over time, the faith investors are likely to have in management, and that is likely to lead, eventually, to a recognition that the firm is foregoing real opportunities in favor of financial engineering and balance sheet decorating.
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Buybacks can be very material for a company. For example, if a company needs to make a large adjustment to its capital structure, this is one way to make an instantaneous change. Additionally, companies that grant large stock options can repurchase stock and reissue those shares when options are exercised. This precludes dilution! Another example would be a large sale, such as a division. This would be an effective way to distribute the cash. If they dramatically bumped up the dividends, they almost certainly would have to decrease them again for which the public is not very accepting.
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I like ZB's take, and agree with it for the most part. Just a few comments to add:

More than likely, if anything, repurchases may rob a little shareholder value based on these common factors.

1. To get any significant value from a repurchase, the stock should be well undervalued. Company managements are probably not the best judges of their own firms value and will probably tend to repurchase at too high a price.


Strongly agree here. The gist of my point, I think, is that it's better to allow the market as a whole to make its own net choice under most circumstances. A buyback program will only have some marginal effect in maintaining shareholder value *if* the firm is truly undervalued and the buyback results in a significant decrease in shares outstanding making the remaining shares each represent a slightly larger fraction of the enterprise as a whole.

2. Many buybacks are just a way to get shares into the treasury to make them available for employee options without having to issue new shares.

I'm a little mixed in my opinion here, largely because I'd prefer, as an investor, to see less option compensation overall. As long as options compensation remains attractive (or necessary) to firms, wouldn't you prefer to see the firm accumulate the shares it expects to distribute on exercise of outstanding options at a relatively low price, rather than have them issue dilutive shares or buy shares for options at or near the exercise price?

3. Dollars spent on share repurchases, even in the best circumstance, are a one time benefit. The same dollars well reinvested in the company would have a compounded shareholder value return over time.

Wholly agreed.

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thalseth,

I agree they can be material if large enough and done for some of the reasons you mention.

My sense, though, is that, it has become relatively rare to see buybacks used in this way. Or perhaps another way to say that is that buybacks *seem* to have become increasing common in recent years (then again, so have falling market valuations for older companies and firms which once had great reputations for stable, reasonably predictable growth.

At least half the equities I've chosen to hold in the past 6 months have announced a buyback plan within the last 2 years (most more recent than that), and my sense is that what I'm seeing in the 10-Ks I've read most closely is also true for a large percentage of the other companies out there.

The particular cases you mention also happen, to be sure, but there are a lot of buybacks that are not especially large and for which one has to ask some questions about whether the stated rationale for the buyback really has full credibility, or whether it amounts to a (not particularly successful) attempt to jawbone a company's stock price out of free-fall, sometimes at prices that are not necessarily outside the range of realistic DCF valuations.

Of course, a buyback that turns out to be executed within range of the real lows is likely to enhance investors' estimates of management competence, even though I'm sure there is no small amount of luck involved in determinging which turn out to look like the "smart" buybacks.
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"...or whether it amounts to a (not particularly successful) attempt to jawbone a company's stock price out of free-fall, sometimes at prices that are not necessarily outside the range of realistic DCF valuations."
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I read recently that the average company's stock rose 3.5% the day a buyback was announced, and that companies which repurchase shares outperform the market over a four-year period following the announcement. Why does this happen? It tells the investment community that the stock is undervalued, and the company believes its own stock is attractive. I understand there will be companies who misuse this form of cash distribution, but on average, it appears more effective than putting the money in subpar investments. The number of companies using stock repurchases continues to rise exponentially.
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thalseth,

IF statistics show that there is a high correlation between stock repurchase and 4 year price performance, AND IF the number of companies using stock repurchase as a financial management strategy is, as you say, "ris(ing) exponentially" THEN does it not stand to reason that an increasing percentage of those adopting the strategy are likely to be below-average performers whose stocks are NOT in fact undervalued?

This would seem to be a clear formula for a speculative bubble, assuming that investors were so naive as to persist in awarding a price premium to those companies that engage in repurchase, without regard to other factors.

Do you have numbers on how this correlation has changed over time? Particularly in recent years? I thought I recalled someone (ZB, perhaps?) suggesting that the law of diminishing returns has already had an impact as this particular practice has taken on the appearance, at the very least, of a form of financial engineering?
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Here are the references:

David Ikenberry, Josef Lakonishok, and Theo Vermaelan, "Market Under-Reaction to Open Market Repurchases," Rice University Working Paper, June 1994

"Buybacks Make News, But Do THey Make Sense?" Business Week, Aug 12, 1996, 76
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Thanks for the references.

I noticed the most current was about 4 years old. Far more interested in seeing how things have or have not shifted over the last 4 years than in what was recorded prior to the market's unprecedented run of the last 3 years (prior to this one, that is), but I'll check them out if I have time to locate them. Have a feeling I've read the Business Week article before, or at least something similar.

Note to self: research this.
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Interesting thread - Buffett had a section in his 1999 chairman's letter worth reading...

http://www.berkshirehathaway.com/letters/1999htm.html

>>-------------------
Share Repurchases



Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests were rationally based, but a few leaned on spurious logic.

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).

When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.

That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.

Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can't help but feel that too often today's repurchases are dictated by management's desire to "show confidence" or be in fashion rather than by a desire to enhance per-share value.

Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This "buy high, sell low" strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.

Of course, both option grants and repurchases may make sense -- but if that's the case, it's not because the two activities are logically related. Rationally, a company's decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options -- or for any other reason -- does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).

You should be aware that, at certain times in the past, I have erred in not making repurchases. My appraisal of Berkshire's value was then too conservative or I was too enthused about some alternative use of funds. We have therefore missed some opportunities -- though Berkshire's trading volume at these points was too light for us to have done much buying, which means that the gain in our per-share value would have been minimal. (A repurchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value produces only a ½% gain in that value at most -- and even less if the funds could alternatively have been deployed in value-building moves.)

Some of the letters we've received clearly imply that the writer is unconcerned about intrinsic value considerations but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer wants to sell tomorrow, his thinking makes sense -- for him! -- but if he intends to hold, he should instead hope the stock falls and trades in enough volume for us to buy a lot of it. That's the only way a repurchase program can have any real benefit for a continuing shareholder.

We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders -- and potential shareholders -- the same valuation-related information we would wish to have if our positions were reversed.

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money. At best, repurchases are likely to have only a very minor effect on the future rate of gain in our stock's intrinsic value.

>>-----------------------
-SkunkyBeer
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Pretty much says it all. Thanks SkunkyB.

Bruce
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Dear y'all,

Interesting comments on buybacks etc. A couple of comments:

Dollars spent on share repurchases, even in the best circumstance, are a one time benefit. The same dollars well reinvested in the company would have a compounded shareholder value return over time.

Sure, this is true. But dollars spent in a company project may only have a "one-time" impact as well.

IMHO capital allocation problems are hard for most companies. When you have a fast-growing "niche" company, they may not be - just throw money at your core product. Otherwise it isn't easy figuring out how best to spend your money...

I have no statistics on the effectiveness of buybacks. I had heard though that, in general though, mergers destroy value more often than they create value. So purchasing other companies isn't necessarily a better deal in general than buying back shares.

Lleweilun Smith
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Dollars spent on share repurchases, even in the best circumstance, are a one time benefit. The same dollars well reinvested in the company would have a compounded shareholder value return over time.

The issue guiding the allocation of excess cash in a public corporation should be (I wish I could say "is", but unfortunately that would be inaccurate) what will provide the best return on that cash for the shareholders.

If the enterprise's asset allocators can honestly say that the best return is to put it into the business itself (expand capacity, expand outlets, R&D, etc.) that should be done.

However, it is true that sometimes owing to where the enterprise is in its life cycle or owing to other conditions the honest prediction is that the shareholders themselves can invest and make a better return for themselves than "growing" the business.

It is certainly tempting for corporate executives to always think that their own business skills are such that the answer is always to put the money into the business itself, but those more honest with themselves may well come to the conclusion that they cannot do better than some benchmark available to the shareholders, such as maybe AAA corporate bonds.

The availability of compounding is not exclusive to investing excess cash back in the business itself in some way. Shareholders can get compounding by investing the dividends or proceeds from selling shares back to the enterprise by putting those proceeds into another stock, into bonds, etc.

Should the corporate executives determine that money should be returned to shareholders then the question they next need to answer is whether to do so through the repurchase of shares or by the issuance of dividends, and that's another subject.



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I had heard though that, in general though, mergers destroy value more often than they create value.

Diworsification is the term Peter Lynch coined for it - and I think the term is fairly applicaable.

Dollars spent on share repurchases, even in the best circumstance, are a one time benefit. The same dollars well reinvested in the company would have a compounded shareholder value return over time.</i

How is a stock buyback a one time financial benefit? Am I missing some simple math?

A stock buyback will increase your share of the company, your share of the comany profits, and your share of future company profits.

If a company increases your share of the company through a stock buyback, and the earnings of the company continute to grow, then you've been giving an additional earnings stream that will continute to compound - without any cost you you.

It seems to me that buying back stock offeres the same return that an investor would receive if he were to buy the stock at a particular price.

Did that make sense at all?

-Ortman
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Great, informative thread everyone!

Everyone has hit on the usual reasons for stock buybacks and dividend policies. I believe one reason is missing (sorry if I missed it).

Company's with too much excess cash can become targets for hostile takeovers. Confronted with this "problem" I'd prefer a company to offer dividends or stock buyback then attempt some wily-nily idea.

And not every dollar at ones disposal can be allocated for profit maximization. Most of us own stocks, but we probably all have some form of savings earning 4%. This applies to companies also (IMO).

Ryan
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Ryan68:
Most of us own stocks, but we probably all have some form of savings earning 4%. This applies to companies also (IMO).

4%!? Sounds like you need to switch banks.

www.bankrate.com

;)

-Ortman
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Dear Ryan,

Company's with too much excess cash can become targets for hostile takeovers. Confronted with this "problem" I'd prefer a company to offer dividends or stock buyback then attempt some wily-nily idea.

I do not know what you meant by putting "problem" in quotations. IMHO, as a shareholder it isn't a problem though, since usually takeovers occur at a premium to market value.

Of course, an employee in the purchased company may differ in his opinion :) But from a shareholder's point of view, IMHO the "excess cash" problem is probably overstated.

Lleweilun Smith
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Lleweilun

I do not know what you meant by putting "problem" in quotations.

The "problem" here was excess cash. To most of us that would be quite a pleasant problem, thus the quotes.

as a shareholder it isn't a problem though, since usually takeovers occur at a premium to market value.

Agreed, and in a lot of instances one would be wise to sell into this premium.

Of course, an employee in the purchased company may differ in his opinion

They'll all be sipping Champagne and Toast their ESO's: )

the "excess cash" problem is probably overstated.

Lost me here, would you mind expanding?

Ryan



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Dear Ryan,

jmls said:

the "excess cash" problem is probably overstated.

Ryan68 said:

Lost me here, would you mind expanding?

Nothing really profound...

I had read some places that companies shouldn't accumulate too much cash because that makes them takeover bait and it says they aren't efficiently allocating resources etc. Also I have read that if a company has too much cash it encourages them to spend it foolishly.

All I'm saying is that, while this may happen, it looks like more companies accumulate too little cash than too much cash IMHO...

Lleweilun Smith
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Hi everybody,

There's a related article on buybacks in Forbes June 12, pg 390.

ZB
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Stock buy-backs I would say are mostly positive. The debatable part is when an underperforming company implements such a program.

The most efficient use of this management tool for me, is when a company with a siginifcantly depressed stock price, and good fundamentals buy their stock back. I say this, because there is nothing more frustrating to me in investment, than when a lumbering giant makes a hostile bid for a high growth company with a depressed stock price.

On the other hand, it is also the fiduciary duty of management to examine any reasonably priced merger bid.

But again, my concern, as a stockholder of a small or mid-cap company which is doing well, is that I do not want to become part of a company which may only be growing above the market rate as a result of continually merging with smaller entities.

Stock buy-back is the best protection a company can trigger, even if it means raising the debt level.

But any company which does implement a program, has hopefully explored other means for use of the funds available.

This is a broad subject, I have merely touched the issue, and each company's case has to be taken on its own merits.
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