Summary
This article is important in that it highlights an ever increasing trend of buying back shares in an attempt to increase stock price.
Analysis
In general, if markets are efficient and an asset is fairly priced, then there shouldn't be any excess returns at all and everything is a zero NPV project in theory. I usually say there are three reasons why a stock price should go up upon a share repurchase: (i) Financial / Mathematical: reduces shares outstanding, increases EPS, constant PE, stock price up; (ii) Behavioral Finance: signaling effect, mgmt thinks stock undervalued, buy low, sell high; and (iii) Economic: reduced supply, increased demand. But in each of those three cases, it's the market's inefficient response!
Conceptually, the lack of value creation makes sense. The answer somewhat lies in the debt / equity ratio. To better illustrate this, recall the fundamental relationship between enterprise value, equity value and ultimately, stock price. The total enterprise value of the firm will not change depending on how you alter your mix of capital structure (addressed in our Corporate Valuation and Corporate Finance class). What you are doing is altering your capital structure by buying back shares. Equity value is simply the "residual" of enterprise value after Net Debt. So if you increase your debt or reduce your cash to buy back shares, by definition, your equity value will decrease. Again, that's because our assumption is that enterprise value doesn't change. This decrease in equity value is perfectly offset by the reduction in share prices. Take a look at the following short example and you'll see why this works:
Scenario: Buy back $30 worth of stock using excess cash or by borrowing more debt:
Status Quo
TEV 1,000.0
Debt 200.0
Cash 50.0
EV 850.0
Sout 100.0
Price 8.5
Use Cash
TEV 1,000.0
Debt 200.0
Cash 20.0
EV 820.0
Sout 96.5
Price 8.5
Use Debt
TEV 1,000.0
Debt 230.0
Cash 50.0
EV 820.0
Sout 96.5
Price 8.5
Now, some cite the effect of the tax shield on interest expense as another possible explanation. Whether you increase debt or decrease cash to buy back shares, either way, your Pre-Tax Income goes up because of the extra interest expense or reduce interest income. Net Income therefore goes down, resulting in lower EPS. The question becomes, do these changes exactly offset each other? The answer is yes, they do, and so the EPS also stays the same. Assuming a constant PE ratio, there should also be no change to stock price. See below example, building off above example (10% interest income and interest expense and 40% tax rate):
Status Quo
EBIT 100.0
Interest Expense 20.0
Interest Income 5.0
EBT 85.0
Taxes 34.0
Net Income 51.0
Sout 100.0
EPS 0.51
Use Cash
EBIT 100.0
Interest Expense 20.0
Interest Income 2.0
EBT 82.0
Taxes 32.8
Net Income 49.2
Sout 96.5
EPS 0.51
Use Debt
EBIT 100.0
Interest Expense 23.0
Interest Income 5.0
EBT 82.0
Taxes 32.8
Net Income 49.2
Sout 96.5
EPS 0.51
Therefore, if capital markets are efficient (at least in the long run) large share repurchases and recapitalizations (short of an LBO) fundamentally do not create excess value.
