Stock buybacks shouldn't change stock prices

Companies are owned by the shareholders. Companies try to make profits. And when they do, some combination of three things happens with those profits.

1. They get reinvested in the company.
2. They get paid out as a dividend.
3. Some shareholders are bought out in a stock buyback.

The mechanism of the first two is generally understood. But there is widespread misunderstanding of the third. Inevitably when a stock buyback is announced, you'll find articles that insert helpful explanations about how stock buybacks increase the stock price, helping investors.

Every time you see one of those explanations, I guarantee you that the person who wrote it is ignorant about basic financial matters. That appears to be most of the media.

Why, you ask? Because changing the stock price is not the purpose of a stock buyback. And to first order there is no effect on stock price. The reason for that is that the stock price is the value of the company divided by the number of shares. As the company buys back its stock, the value of the company drops by the money spent, and the amount of stock outstanding drops the same. Investors are rewarded by having those who wish to be bought out, bought out. And, unlike with a dividend, investors who didn't want to sell don't get taxable income.

So, for instance, if a company worth $50 billion with 10 billion outstanding shares of stock buys back $5 billion dollars, then the value of the company drops from $50 billion to $45 billion (because it spent $5 billion in cash), the amount of outstanding stock drops by 1 billion, and the remaining 9 billion shares are still valued at $5/share. This is finance 101 stuff. It falls right out of the CAPM.

Now I made a comment about "first order". Why? Well because there are several second order effects that realistically could cause stock prices to move. What sort of second order effects could those be?

• It is always hard to buy large amounts of stock without increasing the price (and thereby cause inefficiency in your purchases). However buybacks are always announced in advance prominently enough to let interested shareholders know this is a good time to sell off large positions, so it works out.


• Different investors have different opinions on the true value of the company. The ones you buy out tend to be the more pessimistic ones, leaving you with people who think the stock is worth more. This effect is generally small.


• The market has many people who are confused about finance and who may expect prices to go up. If lots of people expect prices to go up, that's a self-fulfilling proposition. But it tends to be a temporary self-fulfilling proposition, and Wall St is very good at earning money from people predictably making such mistakes.


• The company's cash holdings fluctuate less in value than the other assets that make up the company. Therefore as the relative balance of cash and other moves towards being more heavily weighted with "other", the volatility of the stock price increases. If you've studied options you'll know that increased volatility increases the returns for people holding options. Those returns come from somewhere, and the somewhere they come from is existing shareholders. Therefore the stock price should drop slightly. In theory. If investors are informed enough to pay attention.

I have no idea what the net result of these effects is on current stock holders. However all of the listed effects improve returns for option holders. Given that the people who make decisions about how to return money to shareholders (typically the CEO and board of directors) also tend to be the largest holders of long-term options, I have to wonder whether the ever-growing popularity of stock buybacks has more to do with avoiding giving investors unwanted ordinary income, or with improving the value of options held.