There is Nothing Magical about Stock Buybacks

Confused stories about companies buying back their stock in tax reform’s wake suggest a few reminders about buybacks may be in order.

For starters, a company buying its own stock is fairly commonplace as an alternative means of distributing earnings. Also, in general, stock buybacks don’t change stock prices (unlike dividend distributions) and they don’t change shareholder net worth. This isn’t financial wizardry, folks. Given the recent reporting, you can be forgiven if you’re surprised by these statements.

When a corporation has greater cash holdings than it can reasonably invest or needs for cash management, it generally pays out the excess, most typically by paying a dividend. After a dividend is paid, the company has fewer assets and so the share price falls by the amount of the per share dividend. The shareholder accepts the drop in share price because the shareholder now has the dividend. The shareholder’s total wealth is unchanged, only the composition of wealth changes to more cash, less equity investment.

For example, suppose a company has issued 100 shares and holds $100 in cash, and suppose the discounted present value of its future earnings is $900.  The company’s total value is then $1,000 and its share price is $10.

Suppose the company distributes the $100 cash as a dividend. The company’s value drops to $900 and its share price drops to $90. The shareholders now have $100 cash and $900 in equity, or $1,000 from owning the company, just as before the dividend.

In lieu of a dividend, suppose the company distributes the $100 by buying back 10 shares at $10 each. The company is now worth $900 but there are only 90 shares outstanding, so the share price remains $10. Notice – contrary to many reports, share prices generally don’t rise from a stock buyback unless the market interprets the buyback as some kind of additional signal from management: No signal, no price rise. The shareholders collectively still have $1,000, but the composition is now $900 from owning the company and $100 cash from stock sales.

Tax reform has triggered a wave of bonuses and wage hikes to workers and extraordinary dividend payments and stock buybacks for shareholders. This is just the beginning of how tax reform will help American households. The bigger story will unfold in the months and years to come as business investment is stronger as a result, overall growth is stronger, jobs more plentiful, and both wages and shareholder payouts are higher.

Some of these payouts to shareholders will continue to be in the form of stock buybacks, and no doubt some commentators will continue to agitate at the practice. Just remember, stock buybacks are just another means of distributing earnings. Unless you’ve got a beef with corporations paying dividends, there’s no reason to get worked up about stock buybacks.

About the authors

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.