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TechnologyStock buybacks are no disease. Here's how they really work

18:05  13 september  2019
18:05  13 september  2019 Source:   financialpost.com

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Investors, listen up. In this video, we break down what stock buybacks are and how they can make you money.

Stock buybacks , although they can provide benefits, have been called into question in recent years. There' s been a large rise in buybacks over the last decade, with some companies looking to take advantage of undervalued stocks , while others do it to artificially boost the stock price.

Stock buybacks are no disease. Here's how they really work© Brent Lewin/Bloomberg Bank towers in Toronto's financial district.

Stock buybacks are a disease! They suppress wages, drive inequality and destroy whole economies. So the Post reported on Aug. 21, in the article, “’The American Disease’: Canadian companies pouring cash into stock buybacks as backlash grows abroad.” As a professor of finance and an expert on stock repurchases, I would like to clarify a few misconceptions and explain how stock buybacks work.

An important mistake is the claim that “the allure of buybacks … is that they can boost stock prices …” The argument goes like this. Repurchases reduce the number of shares outstanding, which increases earning-per-share and the price-earnings (P/E) ratio. If corporate value is a multiple of the P/E ratio, then the company’s value rises. But that isn’t how corporate value is determined. Corporate value is the market’s estimate of discounted free cash flow (plus non-productive assets like cash). The stock price is that value divided by shares outstanding. A stock repurchase affects both the numerator and denominator so its impact on price is ambiguous.

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We explain what is a stock buyback and why many share buyback programs are bad for long term investors. You will learn when share buybacks are good If you join that list you will have access to all the free courses that I am working on, when they are available, as well as significant savings on any

If buybacks are restricted, expect dividends to come into favor again. Because of the funky corporate structure, it is hard to value Dell. What is it really worth without its massive stake in VMware? But that’ s not how tech stocks work . When a company stops growing, it starts dying.

A buyback at a fair price has no impact. Imagine a company with one asset: $100. There are 10 shares outstanding so each share is worth $10. Assume two shareholders each hold five shares. The company decides to buy back two shares at $10/share. Assume each shareholder sells one share. After the repurchase, the company has $80 of cash and eight shares outstanding. The stock price hasn’t changed — it’s still $10. Each shareholder has four shares and $10 of cash, so there is no change in shareholder wealth either. All that has changed is the form of the wealth: it is now a mix of shares and cash. The repurchase acts like a dividend: it distributes cash to the shareholders.

My research finds that the average repurchase announcement increases the stock price by about 2.5 per cent (over and above the market). The source of this gain is signalling and not manipulation. Shareholders infer that repurchasing companies will have higher free cash flow in future — which may actually be what companies are signalling.

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To put it differently, this video explains that stock buybacks are tools and nothing more, therefore not inherently good or bad: it all depends on how you use them . If used in an ethical manner, share buybacks make perfect sense. On the other end of the spectrum, however

The top 20 stock buyback programs in corporate America have spent .4 trillion buying back their own shares since the Great Recession ended. But how many of those 20 stocks have outperformed the S &P 500 since 2009? Only five. Now is no time for buybacks .

Four other common errors are:

First, that insiders use buybacks to cash out. That may happen occasionally, but my research shows the average insider is honest: she earns no abnormal returns on her trades. If some insiders do take advantage, then that is either a regulatory matter for the relevant securities overseer or a contractual matter for shareholders and the insiders to sort out. For example, many companies institute black-out periods during which insiders are prohibited from trading.

Second, that repurchases are a tax dodge. The tax on a repurchase is the tax on the capital gain associated with selling the shares. If shareholders sell when the company buys back, then they pay tax in the same year. But shareholders have the option to wait. If they do wait, then they don’t get any cash and shouldn’t have a tax liability.

A third error is the worry that “… companies (are) leveraging up and funding buybacks with debt.” Debt is not the devil’s brew. Corporate finance includes Nobel-prize winning theories about the optimal capital structure — and it isn’t zero debt. When a company has too little debt, a debt-financed stock repurchase is the textbook example of how to increase leverage.

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These are the real -world consequences of panic buying – a phenomenon that Panic buying helps people feel in control of the situation, experts say. “Under circumstances like these, people feel the need to do something that’ s proportionate to what they perceive is the level of the crisis,” Taylor says.

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A fourth recurring criticism worth mentioning is that companies should use profits to raise wages and invest in new projects — not buy back shares. The article paraphrases William Lazonick, who believes Apple has innovated less since it began buying back stock. This claim reflects the hubris of the central planner. What does Lazonick know of Apple’s reinvestment opportunities? In any event, the causality most likely runs the other way. The dearth of projects is most likely attributable to Steve Job’s demise and to the maturing of the computer/phone market. Value-maximizing companies don’t repurchase if they have attractive projects to invest in. But if companies lack for good projects, the best thing they can do with excess cash is distribute it to owners rather than squander it on money-losing projects. Shareholders can then reinvest the cash in companies with more profitable projects, thus increasing employment and wealth across the economy. Who better to make that reinvestment decision than the shareholders? They have skin in the game.

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But the article really isn’t about stock repurchases. Its message mirrors one by U.S. senators Chuck Schumer and Bernie Sanders. In a New York Times op-ed earlier this year, they argued for a law requiring companies to obtain permission before returning profits to shareholders. Permission would be conditional on the company’s social justice actions (e.g., its sustainability, diversity, inclusivity and equity). But such a law would violate the U.S. Bill of Rights, which entitles owners to the enjoyment of their property. Like the senators, the Post seems to be arguing that workers should control the means of production — not owners. The history of that sort of economic system does not recommend it.

The Post article quotes a critic of buybacks as saying the corporate goal of maximizing shareholder value is an “ideology,” using the word as a pejorative. But value maximization is the foundation of the moral argument for why the market system is good for society. As Adam Smith explained over 250 years ago: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

William J. McNally is a professor of finance at Wilfrid Laurier University.

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