The stock market has done well recently and some commentators have ascribed this, in part, to the influence of share buyback programs. This is puzzling on the surface, because in theory this is not an effective use of a company’s cash. If you assume that the cash is simply an asset that is factored into the stock price completely, then a buy-back should make no difference. In many cases the shares fall, suggesting that the objective of trying to raise the stock price may not easy to achieve. However the enduring popularity of these programs suggests deeper explanations.
One way to look at share repurchases is that company management is sending a signal to the market that inside information (which by definition is not in the price – one assumes), would value the stock at a higher price. Given that, the sellers would ask for more than the existing price to sell their stock, so bidding up the price to a sustainable higher level. Most repurchases are indeed at higher than market price. Maybe, though, the managers are bluffing, and are sending a false signal, since it is in their personal interest to get a higher share price.
A second approach is to consider what the company is signaling about its interest rate expectations. Share buybacks make sense if the interest rate is low and is expected to remain so for the immediate future, i.e. before the cash pool can be refreshed by more profits. Maybe the stock market views this as a generally bullish sign. More subtly, managers might see a large cash holding as a sign that the company expected a decline in its credit rating and a subsequent increase in borrowing costs, against which it needed a cash hoard.
Possibly the market sees this as a positive sign that the company is not going to make foolish cash-financed acquisitions. Since most of these schemes are wealth-destroying, investors may see this as a positive signal.
So, if a buyback succeeds in raising the share price it is more because of a change in investor sentiment than any reality in corporate finance. Why do these then sometimes fail, being followed by a fall in the share price? Well, to start with, the market capitalization will logically fall following a purchase, since there is a certain asset, cash, that has been taken out of the company and given back to former shareholders. Earnings will also fall, because whatever interest income the cash yielded is no longer available to the company. This, as I said earlier, should theoretically be compensated completely for by the reduction in the number of shares outstanding, leaving price unchanged. My point is that there is no law that says the price should go in any particular direction.
One can certainly think of negative messages the market might infer from a company’s share purchase. “They have nothing better to spend their cash on…” or “If they think they are going to throw off cash regularly, why don’t they just increase the dividend”
Maybe the deciding research would be to examine all share repurchases both announced and unannounced and determine the results some time afterwards. My bet is that unannounced, stealth buybacks have little impact on the price. Programs announced with much fanfare, involving a large proportion of the shares outstanding will have the most impact, especially if there is rather less stock actually purchased than the company announced originally.
