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Wednesday, October 26, 2005

Stock Repurchases and Shareholder Wealth

Jeff at Jeff Matthews Is Not Making This Up has put up a short post on share buybacks and enhancing shareholder value:
Companies love to talk about “enhancing shareholder value.”

They usually do so when announcing share buybacks that frequently have very little to do with “enhancing shareholder value” and more to do with preventing earnings dilution caused by the generous option grants which the insiders who control the corporate money spigot give themselves, in the interests of “aligning management with shareholders.”
For all the self-congratulatory claptrap, when companies buy back stock it offsets the added shares from all those options grants and helps inflate the “Earnings per Share” calculation so as not to rouse the shareholders’ ire.

According to DuPont’s management, which announced a large share repurchase yesterday morning, the difference between their repurchase and others is that only about half of all announced share repurchases actually get done. (DuPont did not wait around to buy back stock in the open market: instead, the company bought $3 billion worth of stock from a Wall Street firm, which presumably shorted the stock to DuPont.)

One company that probably wishes it had not followed through on its buyback announcements must be Lexmark, the beleaguered printer company which earlier this month announced the biggest earnings miss I can remember at a mainstream technology-related company.
Click here for the whole thing

I was originally going to respond to some of the comments in his blog, but after a few paragraphs I realized that it's worth a full blown post of its own. So, here goes.

There are a lot of academic studies that focus on buybacks. There are usually several "theories" (for the uninitiated, a theory is a fancy academic word for a story) about why buybacks might be shareholder-wealth enhancing. They generally fall into two main camps:

1) The managers are trying to "signal" that the shares are undervalued.

One of the linchpins of academic financial theory is the idea of "information asymmetry". This term refers to a situation where corporate insiders have better information than those outside the firm (and just as important, the outsiders know that the insiders have superior information). As a result, outsiders study managers/insiders' actions in order to figure what their private information is. This gives managers an incentive to "signal" good information.

The key behind the idea of signalling theory is that a signal has to be credible. In other words, there has to be something that makes it harder for a "bad" firm to send the signal than it is for a "good" firm". If not, both good and bad firms could send the same signal, and it wouldn't provide any information.

In the case of a buyback, the signal from a buyback would be more "credible" if the insiders "put their money where their mouth is". The best way for them to do this is if they have significant holdings in the company, and if they elect not to sell the shares back. That way, if the firm really isn't undervalued, a buyback would hurt them.

As an example, let's assume that the company's stock is selling for $50, and managers' private information indicates that it should be selling for $60 (in other words, the stock is undervalued by $10 per share). So, buying the company's shares back at some price between 50 and 60 (it has to be greater than $50 or no one would sell their shares) would be a good investment for the firm. If the managers have significant stockholdings (and they elect not to sell their own shares back to the company), they have just decreased the amount of shares outstanding, and purchased them "on the cheap" (i.e. at a price below their true value). So, they have taken an action that's in their own best interests.

Instead, lets assume that the firm's true value was $40, and that managers announce a repurchase at $50. In this case, if the managers hold onto their own shares, they have just destroyed some of their own wealth (they overpaid for company shares).

2) The other typical "buybacks are good for shareholders" story has to do with what we call an "agency" problem. An agency problem occurs whenever one party delegates resposnibility to another. The agent (the one who is delegated the responsibility) always has incentives to do things that are in their own interests but not in the principal's (the proncipal is the delegator). In a publicly held firm, the managers are the agents of the shareholders.

One agency problem arises from what we call "free cash flow". From an academic perspective, a free cash flow problem arises when the company has more cash on hand than it has good things to invest it in. The idea is that if the managers hold onto the cash, they will invest it whether the investment is wealth creating or not. Take the example of "empire building" - buying other companies to create a bigger firm. Managers have incentives to do this (higher compensation, more prestige, better perquisites, etc..) whether it's in shareholders interests or not.

So, a repurchase removes this cash from managers' control and pays it out to shareholders. As a result, there are lower "agency costs", and firm value rises. Think of it as good news that shareholders have dodged a bullet - if they hadn't paid out the cash, managers would have made dumb (or self-serving) investments with it.

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