Share buy-backs and shareholder value – why today’s Financial Times is wrong

In the FT today there was on article regarding whether or not companies should buy back their shares. Unfortunately this was based on a flawed underlying analysis, so I thought I’d publish a quick response here.

Dear Tony,

in today’s FT you have published an article, arguing that companies generally get the timing wrong when buying back their shares (ie, they tend to overpay) and that this is bad. Whilst I can see your argument why thismight indeed be the case, it is a fallacy to believe that this is a bad thing. If you argue this way you fail to see that the underlying question is not what the company is worth, but what the aggregate value of the company’s shares is to its shareholders in the “second” before the buy-back is executed. This is an important distinction, as in the case of a share buy-back the two are not identical.

Arguably at every given point in time a company should be optimising aggregate shareholder value for current shareholders. It is easy to see that this is not effected by a buy-back at any price. The only thing that happens is that value is transferred between different groups of shareholders: if the company overpays, then those that sell at this point will gain, those that don’t will lose. If the company underpays it is the other way round. This is not unusual though: shareholders that sell an overvalue company tend to make a profit, and vice versa.

Now you could argue that a company should not favor one group of shareholders over the other. This is in principle right, but not applicable in this case as every shareholder can decide for himself to take up the offer or not. In fact – if one were to believe your argument, then one could simply arbitrage this: sell shares (short, if necessary) after a buy-back announcement, and buy them back after the company has executed the buy-back.
A share buy-back is really like a dividend except that – in some jurisdictions – it is more tax efficient. So a company should firstly decide whether or not it has excess cash (ie significantly more than it can profitably invest), and if this is the case it should return it to its shareholders. In the second step, it should decide which method is more tax-efficient, dividend or buy-back, and use this method. The current share-price of the company should not at all be a factor in the decision whether or not to buy back shares – as argued above, whether a company is over/under/fairly valued is a decision that should be left to its shareholders.

Kind regards
Thor Falk

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