Stock Buybacks: How they work & What's going on

Excerpt relating to Part 1: Buybacks and Stock Prices: Good or bad news? – via Musings On Markets (click here to read)

The net effect of all three of these variables will determine the stock price impact of stock buybacks. Using them to make overall judgments, here is what I would expect to see in response to a stock buyback:

  1. The most positive impact on stock prices should be at mature firms that have a history of earning poor returns on operating assets and are under levered. You get a triple whammy at these firms: the market probably is discounting cash at these firms because it does not trust the management, the firm is under levered and there is little likelihood of the buyback being viewed as a negative signal (since expectations for growth were low to begin with).
  2. The most negative impact on stock prices will be at high growth firms with a history of generating high returns on operating assets and little debt capacity. Cash at these firms is unlikely to be discounted (and may be even be viewed as a strategic asset), there is little potential for value gain from financial leverage and the buyback is more likely to be viewed as a negative signal about future growth potential.

Excerpt relating to Part 2: Stock Buybacks: What is happening and why?

S&P’s most recent update indicates that US companies, after a pause for about a year after the banking crisis, are back in the buyback game. In the third quarter of 2010, the S&P 500 companies bought back almost $ 80 billion of stock, up 128% from the third quarter of 2009. Note that this is part of a long term shift away from dividends towards buybacks in the United States, as is evidenced by the figure below which reports total dividends and buybacks at US companies starting in 1988:

So, what has caused this  movement away from dividends in the last two decades? It cannot be that dividends are taxed more heavily than capital gains: Note that dividends have been taxed at much higher rates than capital gains going back to the early decades of the last century. In fact, in 1979, the highest marginal tax rate on dividends was 70%, while it was only 28% on capital gains. The changes in the tax laws in the last three decades have reduced the tax disadvantage of dividends – in fact, they have both been taxed at 15% since 2003 – and cannot therefore be a rationale for the surge in buybacks. It also cannot be attributed to companies thinking that their stock prices were too low, since these buyback surge occurred during the bull markets of the 1990s and 2004-2007, not during down markets.

About Miguel Barbosa

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26. January 2011 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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