In this video workshop, you will discover the crucial chart patterns that candlesticks reveal, how to interpret them and how to use them to pinpoint market turns. Stock buybacks don’t carry this legacy and companies can go from buying back billions of dollars worth of stock in one year to not buying back stock the next, without facing the same market reaction. In a stock buyback, only those stockholders who tender their shares back to the company get cash and the remaining stockholders get a larger proportional stake in the remaining firm. If stock issuance is not conditioned upon expected buybacks, and therefore present in the dividend counterfactual then it seems like a sunk cost.
A stock buyback has more subtle tax effects, since investors who tender their shares back in the buyback generally have to pay capital gains taxes on the transaction, but only if the buyback price exceeds the price they paid to acquire the shares. To illustrate the effects, let’s start with a simple financial balance sheet (not an accounting one), where we estimate the intrinsic values of operating assets and equity and illustrate the effects of a stock buyback on the balance sheet. They bought shares at inflated prices from exiting stockholders at the expense of current stockholders.
This is one of the few scenarios where a stock buyback, funded with cash, is an unalloyed plus for stockholders, since it eliminates the cash discount on the cash paid out to stockholders. In summary, buybacks can increase value, if they lower the cost of capital and create a tax benefit that exceeds expected bankruptcy costs, and can increase stock prices for non-tendering stockholders, if the stock is under valued.
To answer this question, I compared the debt ratios of companies that bought back stock in 2013 to those that did not and there is nothing in the data that suggests that companies that do buybacks are funding them disproportionately with debt or becoming dangerously over levered. Companies that buy back stock had debt ratios that were roughly similar to those that don’t buy back stock and much less debt, scaled to cash flows (EBITDA), and these debt ratios/multiples were computed after the buybacks. The first is that there is little evidence that companies that buy back stock reduce their capital expenditures as a consequence.
One is that there is firms may buy back stock ahead of positive information announcements, and those investors who tender their shares in the buy back will lose out to those who do not. The other is that there is a tie to management compensation, where managers who are compensated with options may find it in their best interests to buy back stock rather than pay dividends; the former pushes up stock prices while the latter lowers them.