Dienstag, 22. September 2009

Buybacks and Stock Prices

Aswath DAMODARAN on buybacks and stock prices:

"Floyd Norris has an article in the New York Times on stock buybacks:


He notes that buybacks are high when stock prices are high and that they fall off when stock prices are low. His conclusion is that this is irrational because companies should be buying back more stock when the price is low and less when the stock is high. While there is a point to his argument, there are two points he is missing:

1. Buybacks are more about returning cash to stockholders and changing financial leverage than making judgments about stock price: There are two very good reasons, other than the perception that the stock is cheap, for buybacks. The first is that it is an alternative mechanism for returning cash to stockholders, instead of dividends. In addition to providing some tax advantages to investors over dividends, it also allows firms to be more flexible in returning cash over time. (Increasing dividends can be viewed as a long term commitment, whereas buybacks are not.) The second is that it can allow firms that are under levered, i.e., have too little debt in their capitalization, to increase their debt ratio. Buying back stock reduces the market value of equity and increases the debt ratio; if the buyback is funded with debt, the impact is doubled. Thus, one way to explain why companies bought back stock over 2006 and 2007 is that they felt cash rich and a combination of high equity prices and low bond default spreads led them to believe that they were under levered. The crisis may have led them to rethink both assumptions.

2. Even if it is about the price, is not the price per se that matters but the price relative to value: Even if we accept the premise that buybacks are driven by a desire to take advantage of under valued stock, that decision will be driven not by what the price is but what it is relative to perceived value. In other words, a company may buy back stock, when the price is $ 40, if it perceives the value to be $ 50. It will choose not to buy back the same stock, six months later, at $ 20, if the perceived value is only $ 10. The problem with correlating buybacks with stock prices, which is what Norris does, is that it misses the key component of value.

I do think that some US companies, especially in the financial sector, bought back too much in stock in the two years prior to the crisis. I attribute this to the "me too-ism" that is all too prevalent in corporate finance, where firms do, not what's best for them (and their stockholders), but what other firms are doing. Thus, many firms bought back stock because others were doing so, and in a sense, the trend fed on itself."

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