Excerpts from the Book
The popularity of share buybacks has catapulted over the past twenty years. In the United States alone, corporate expenditures on share buybacks as a percentage of earnings are ten times higher today than there were in 1980. In the late 1990s, for the first time companies spent more money repurchasing their shares than on paying dividends. Share buybacks are also flourishing globally. In recent years, countries like the U.K. and Canada have seen an increase in activity while other nations that previous prohibited buybacks, including Germany and Japan, have adopted provisions to make them acceptable. Notwithstanding this surge in popularity, the impact of buybacks on shareholder value—-and hence on the expectations investor—has never been more ambiguous.
Under the right circumstances, buybacks provide expectations investors a signal to revise their expectations about a company's prospects. Indeed, share buybacks are a very effective way for managers to increase their company's share price when they have more bullish beliefs about their company prospects than investors do. Yet the signal is not always clear. Buybacks serve a concurrent of interests, which can leave investors with little if any trace of a meaningful signal.
In this chapter, we develop guidelines for evaluating share buyback programs. We start with our primary interest: to identify when buyback announcements offer a credible signal to revise expectations. We go on to present a golden rule that we can use to evaluate all buyback programs. Finally, we apply the golden rule as a benchmark to evaluate the most popularly cited reasons for share buybacks.
Questions Addressed in Chapter 11
To explore issues surrounding share buybacks, Chapter 11 answers the following questions:
- When are corporate managers sending a positive signal when announcing a share buyback?
- When does a buyback program indicate a negative signal is being sent to the market?
- What is the golden rule of share buybacks?
- What is the shareholder rate of return on cash invested in a share buyback program?
- How has the "politician's pledge" problem weakened the signal sent by the announcement of a share buyback program?
- How do different methods of share buybacks—such as open market purchases, Dutch auctions, and fixed-price tender offers—affect the strength of the signal sent by the announcement of a share buyback program?
- How do other factors—such as the size of the buyback program, the premium to market price, inside ownership, and insider selling—affect the strength of the signal sent by the announcement of a share buyback program?
- How do various factors—such as the P/E multiple and the after-tax interest rates—affect whether a share buyback will increase or decrease earnings per share?
- When does a share buyback offer a tax-efficient strategy for returning cash to shareholders?
- How can share buybacks be used to increase the debt-to-equity ratio for an underleveraged firm? How can this increase shareholder value?
Essential Ideas in Chapter 11
- Share buybacks are much more prominent today than 20 years ago.
- Buybacks can be a prime signal that investors need to revise expectations for a company's value drivers.
- You can rely on the golden rule to measure all buyback announcements: A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
- Companies cite four primary reasons for buying back stock:
- To signal the stock is below expected value.
- To manage earnings per share.
- To return cash to shareholders efficiently.
- To increase financial leverage.
- Investors must critically assess management's motivation for buying back stock. Managers often serve interests other than those of their continuing shareholders.
Please contact the authors via e-mail if you have found a potential erratum in the book.
List of Errata in this Chapter
- The text on page 179 says "when the inverse of the price/earnings multiple [1/(P/E) = E/P] is lower than the after-tax interest rate, a buyback adds to earnings per share. When the E/P is greater than the after-tax rate, a buyback reduces earnings per share." The text should read "when the inverse of the price/earnings multiple [1/(P/E) = E/P] is higher than the after-tax interest rate, a buyback adds to earnings per share. When the E/P is less than the after-tax rate, a buyback reduces earnings per share."