FinanceProfessor.com

 

Why not?

Signed up for FinanceProfessor's free newsletter?

Recycle it is the right thing to do!

The Nature Conservancy

Plant a tree!

Stock buybacks have grown in importance since the mid 1980s.  Find out why!

As its name suggests a stock buyback is when the firm buys back its own shares. 

1. Taxes.  Probably the biggest reason why stock buyback plans have become more important is taxes.  When a company pays a dividend, all shareholders must pay taxes on the dividend.  When a company makes a stock repurchase shareholders have the option of selling.  They can thus chose to avoid paying taxes.  Further, in many countries (including the US where buybacks are most popular) capital gains are taxed at a rate lower than ordinary income whereas dividends are taxed as ordinary income.
2. Signaling  Managers can signal their belief that the stock is undervalued by buying it.  (As an historical note, the importance of this can be seen after the crash of 1987 when most large firms announced buybacks and this was credited by many in helping the market to bounce back.)
3. Flexibility  Dividends are hard to cut.  Stock buybacks offer the management more flexibility in the size and timing of the trades.
4. Stock Option plans An often overlooked reason for many buybacks is to fund employee stock ownership plans.  The firm buys back shares to give to its employees.

• Open market repurchases- here the firm buys its shares back in the open market.  that is they "call" a broker and purchase shares in the same manner any ordinary investor would. This takes some time but is fairly easy and is usually used for relatively small repurchases. 
• Self-Tender offers-this is usually used for larger buybacks.  The firm announces that they will pay A set amount for each share (often up to a limit) that is tendered (given) to the firm.  (A variant of this is a Dutch-Acution Self tender where the firm asks the shareholders at what price they would be willing to sell at.)
• Greenmail-this is a targeted repurchase and is usually used to get rid of onerous shareholders.  Many shareholders do not like this as the buyback is often done at a premium and the shareholders that are not allowed to participate lose out. (Often used as a takeover defense.)

Comment and Jarrell (1991) report that firms experience a 2% abnormal positive return on the announcement of a stock repurchase plan.
 
 

go back to FinanceProfessor.com Main page