VideoThe share price increase from a buyback in theory results purely from the tax benefits of a company's new capital structure rather than from any underlying operational improvement. In the example, the company incurs a value penalty of €18 million from additional taxes on the income of its cash reserves (assuming €200 million in cash, a 3 percent interest rate, and a 30 percent tax rate, discounted at the cost of equity of 10 percent, and assuming that the amount of cash doesn't grow and that it is held in perpetuity). A buyback removes this tax penalty and so results in a 1.4 percent rise in the share price. In this case, repurchasing more than 13 percent of the shares results in an increase of less than 2 percent. A similar boost occurs when a company takes on more debt to buy back shares (Exhibit 2).
We can estimate the impact on share prices from this tax effect (Exhibit 3), but historical and recent buyback announcements typically result in a much bigger rise in share price than this analysis indicates. Research from both academics and practitioners consistently finds that companies initiating small repurchase programs see an average increase in their share price of 2 to 3 percent on the day of the announcement; those that undertake larger buybacks, involving around 15 percent or more of the shares, see prices increase by some 16 percent, on average. Other, more subtle reasons explain this larger positive reaction to share buybacks.
The market responds to announcements of buybacks because they offer new information, often called a signal, about a company's future and hence its share price.
One well-known positive signal in a buyback is that management seems to believe that the stock is undervalued. Executives can enhance this effect by personally purchasing significant numbers of shares, since market participants see them as de facto insiders with privileged information about future earnings and growth prospects. A second positive signal is management's confidence that the company doesn't need the cash to cover future commitments such as interest payments and capital expenditures.
But there is a third, negative, signal with a buyback: that the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere. Some managers are reluctant to launch buyback programs for this reason, but the capital market's mostly positive reaction to such announcements indicates that this signal isn't an issue in most cases. In fact, the strength of the market's reaction implies that shareholders often realize that a company has more cash than it can invest long before its management does.
Therefore, the overall positive response to a buyback may well result from investors being relieved that managers aren't going to spend a company's cash on inadvisable mergers and acquisitions or on projects with a negative net present value. In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what management will do with excess funds.
Such shareholder skepticism would be well founded. In many industries, management teams have historically allocated cash reserves poorly. The oil industry since 1964 is one example (Exhibit 4): a huge price umbrella for much of this period, courtesy of the Organization of Petroleum Exporting Countries (OPEC), provided oil companies with relatively high margins. Nevertheless, for almost three decades the spread between ROIC and cost of capital for the industry as a whole was negative. Convinced that on a sustained basis the petroleum industry could not deliver a balanced source of income, many companies committed their excess cash to what turned out to be value-destroying acquisitions or other diversification strategies. For example, in the 1970s, Mobil bought retailer Montgomery Ward; Atlantic Richfield purchased Anaconda, a metal and mining company; and Exxon bought a majority stake in Vydec, a company specializing in office automation. All of these cash (or mostly cash) acquisitions resulted in significant losses.
With cash levels at an all-time high and mergers on the increase, managers risk repeating past behaviors. Clearly, for cash-rich industries with insufficient investment opportunities, a critical task for boards will be forcing management to pay out the excess cash sooner rather than later. But by allowing management compensation to be linked to EPS, boards run the risk of promoting the short-term effects of buybacks instead of managing the long-term health of the company. Similarly, value-minded executives in industries where good investment opportunities are still available must resist the pressure to buy back shares in order to reach EPS targets.
In most cases, buybacks create value because they help improve tax efficiency and prevent managers from investing in the wrong assets or pursuing unwise acquisitions. Only when boards and executives understand the difference between fundamental value creation through improved performance and the purely mechanical effects of a buyback program on EPS will they put share repurchases to work creating value.
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