Stock buybacks

Stock buybacks are generally seen as a good thing for investors.  buybacks can be done for several reasons: they can be done as a means of giving cash back to shareholders.  In this light they are like dividends but the buybacks have several advantages when it comes to tax treatment: specifically the investor can choose to take the gain or not and generally the capital gains rate will be lower than the ordinary tax rate.  Moreover, the decision to buy the shares of the your own firm suggests that management believes the stock is undervalued. 

There are several ways a firm can do a buyback.  They can use a self-tender offer (or a Dutch self-tender offer),  or the firms can but back shares in the open market.  A final way the firm can do a buyback is through a targeted buyback of shares from a select group of investors.  This selected share buyback goes by the name of greenmail and is often used to rid a firm of troublesome shareholders (including hostile raiders). 

Typically the stock price jumps on the announcement of a share buyback.  However, that is not always the case as the sock buyback also tells investors something about the investment opportunities management feels are in front of the firm.  Specifically a buyback could be interpreted as “we really do not have many positive investment opportunities .  Thus it should not be totally surprising when, in spite of the average positive reaction, a stock price falls on the announcement of a buyback.

One reason that buybacks are often done is to fund employee and executive stock option plans with a dilution that would occur if new shares were to be issued.  In a recent working paper Ken Klassen andRanjini Sivakumar find that the stock price reaction to the announcement of a buyback is less positive when the purpose is to fund an option plan.  This is not surprising, as it is a less strong signal of stock undervaluation. 
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=271478

On other thing that deserves mention with respect to buybacks.  Buybacks are authorized the firms’ by boards of directors.  Some have worried that boards make the announcement of a buyback plan but the firm then does not carry forth with the plans.   Two Michigan State researchers (Altobelli and Wiggins) have largely answered this question.  The answer is that yes, they do generally follow through by the authors acknowledge a wide variation in the repurchases.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=7248
 

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