Stock-buyback programs differ from dividends in that there's no immediate, direct benefit to shareholders: With a dividend, shareholders get cash. But shareholders do benefit indirectly from a buyback or repurchase program, as the goal is generally to raise the company's stock price.
The idea is that by taking shares out of circulation, the remaining shares will be worth more. Think of the company's overall value as a pie: If it's cut into fewer slices, each slice will be bigger. Of course, it doesn't always work out exactly that way in practice. On one hand, just the announcement of a share-repurchase program is sometimes enough to give the stock a boost, before the company has bought any shares. On the other hand, sometimes there's unfavorable news or a shift in the market while the company is in the process of buying its own shares.
In that case, its shares might trade lower for a while even thought the total number of shares outstanding has been reduced by the buyback. Generally speaking, though, a share-repurchase program will tend to boost the stock's price over time. That's not just because of the reduced supply of shares, but because buybacks tend to improve some of the metrics that investors use to value a company. Share buybacks reduce the company's total number of shares outstanding and the total amount of cash on the company's balance sheet.
Those changes affect several metrics used by investors to estimate the value of a company. Once shares are repurchased, they are generally either cancelled entirely -- wiping them out of existence -- or kept by the company as treasury shares. Treasury shares are counted as issued shares, but not as outstanding shares. Reducing the number of shares outstanding affects calculations such as earnings per share, which in turn affects a widely used valuation metric, the price-to-earnings ratio.
Typically, companies can return wealth to shareholders through stock price appreciations , dividends , or stock buybacks. In the past, dividends were the most common form of wealth distribution. However, as Corporate America becomes more progressive and flexible, a fundamental shift has occurred in the way companies deploy capital. Instead of traditional dividend payments, buybacks have been viewed as a flexible practice of returning excess cash flow.
In recent history, leading companies have adopted a regular buyback strategy to return all excess cash to shareholders. By definition, stock repurchasing allows companies to reinvest in themselves by reducing the number of outstanding shares on the market. Typically, buybacks are carried out on the open market, similarly to how investors purchase stocks. Apple investors have grown to prefer buybacks since they have the choice of whether or not to partake in the repurchase program. By not participating in a share buyback, investors can defer taxes and turn their shares into future gains.
Buybacks benefit investors by increasing share prices, effectively returning money to shareholders in a tax-efficient manner. There are many ways profitable companies can measure the success of its stocks.
However, the most common measurement is earnings per share EPS. Earnings per share are typically viewed as the single most important variable in determining share prices. When companies pursue share buyback, they will essentially reduce the assets on their balance sheets and increase their return on assets.
Likewise, by reducing the number of outstanding shares and maintaining the same level of profitability, EPS will increase. Those who do choose to sell have done so at a price they were willing to sell at. When the economy is faltering, share prices can plummet as a result of weaker than expected earnings among other factors. In this event, a company will pursue a buyback program since it believes that company shares are undervalued.
Companies will choose to repurchase shares and then resell them in the open market once the price increase to accurately reflect the value of the company.
When earnings per share increases, the market will perceive this positively and share prices will increase after buybacks are announced. This often comes down to simple supply and demand. When there is a less available supply of shares, then an upward demand will boost share prices. When excess cash is used to repurchase company stock, instead of increasing dividend payments, shareholders have the opportunity to defer capital gains if share prices increase.
Traditionally, buybacks are taxed at a capital gains tax rate, whereas dividends are subject to ordinary income tax. Expected value is the weighted average value for a range of plausible scenarios.
To calculate it, multiply the value added for each scenario by the probability that that scenario will materialize, then sum up the results. Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables?
At the corporate level, executives must also address three questions: Do any of the operating units have sufficient value-creation potential to warrant additional capital? Which units have limited potential and therefore should be candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the most overall value?
Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity. They view EPS accretion as good news and its dilution as bad news. When it comes to exchange-of-shares mergers, a narrow focus on EPS poses an additional problem on top of the normal shortcomings of earnings.
The inverse is also true. Management needs to identify clearly where, when, and how it can accomplish real performance gains by estimating the present value of the resulting incremental cash flows and then subtracting the acquisition premium. Value-oriented managements and boards also carefully evaluate the risk that anticipated synergies may not materialize. They recognize the challenge of postmerger integration and the likelihood that competitors will not stand idly by while the acquiring company attempts to generate synergies at their expense.
If management is uncertain whether the deal will generate synergies, it can hedge its bets by offering stock. The fourth principle takes value creation to a new level because it guides the choice of business model that value-conscious companies will adopt.
There are two parts to this principle. First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets.
Such an analysis is clearly a political minefield for businesses that are performing relatively well against projections or competitors but are clearly more valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value. A recent example is Kmart. Lampert was able to recoup almost his entire investment by selling stores to Home Depot and Sears, Roebuck. Former shareholders of Kmart are justifiably asking why the previous management was unable to similarly reinvigorate the company and why they had to liquidate their shares at distressed prices.
Second, companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities such as research, design, and marketing where they enjoy a comparative advantage and by outsourcing low value-added activities like manufacturing when these activities can be reliably performed by others at lower cost.
Examples that come to mind include Apple Computer, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution.
Value-conscious companies with large amounts of excess cash and only limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks. Not only does this give shareholders a chance to earn better returns elsewhere, but it also reduces the risk that management will use the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions.
Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has nothing to do with whether or not a buyback makes economic sense. When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock option programs.
In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays. Companies need effective pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out appropriate guidelines for top, middle, and lower management compensation.
The standard option, however, is an imperfect vehicle for motivating long-term, value-maximizing behavior. First, standard stock options reward performance well below superior-return levels. As became painfully evident in the s, in a rising market, executives realize gains from any increase in share price—even one substantially below gains reaped by their competitors or the broad market.
Finally, when options are hopelessly underwater, they lose their ability to motivate at all. And that happens more frequently than is generally believed. For example, about one-third of all options held by U. But the supposed remedies—increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options—are shareholder-unfriendly responses that rewrite the rules in midstream.
Value-conscious companies can overcome the shortcomings of standard employee stock options by adopting either a discounted indexed-option plan or a discounted equity risk option DERO plan. To provide management with a continuing incentive to maximize value, companies can lower exercise prices for indexed options so that executives profit from performance levels modestly below the index.
Companies can address the other shortcoming of standard options—holding periods that are too short—by extending vesting periods and requiring executives to hang on to a meaningful fraction of the equity stakes they obtain from exercising their options.
For companies unable to develop a reasonable peer index, DEROs are a suitable alternative. Treasury note plus a fraction of the expected equity risk premium minus dividends paid to the holders of the underlying shares. Equity investors expect a minimum return consisting of the risk-free rate plus the equity risk premium. But this threshold level of performance may cause many executives to hold underwater options.
By incorporating only a fraction of the estimated equity risk premium into the exercise price growth rate, a board is betting that the value added by management will more than offset the costlier options granted. Dividends are deducted from the exercise price to remove the incentive for companies to hold back dividends when they have no value-creating investment opportunities.
While properly structured stock options are useful for corporate executives, whose mandate is to raise the performance of the company as a whole—and thus, ultimately, the stock price—such options are usually inappropriate for rewarding operating-unit executives, who have a limited impact on overall performance. A stock price that declines because of disappointing performance in other parts of the company may unfairly penalize the executives of the operating units that are doing exceptionally well.
In neither case do option grants motivate executives to create long-term value. Companies typically have both annual and long-term most often three-year incentive plans that reward operating executives for exceeding goals for financial metrics, such as revenue and operating income, and sometimes for beating nonfinancial targets as well.
The trouble is that linking bonuses to the budgeting process induces managers to lowball performance possibilities. Yahoo Finance. Harvard Business Review. Wall Street Journal.
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We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Investing Stocks. Key Takeaways Stock buybacks, although they can provide benefits, have been called into question in recent years. There's been a large rise in buybacks over the last decade, with some companies looking to take advantage of undervalued stocks, while others do it to artificially boost the stock price.
Buybacks can help increase the value of stock options, which are part of many executives' compensation packages. Buyback programs can be easier to implement than dividend programs, however.
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