Thursday , June 21 2018

Buybacks

Summary:
A short oped for the Wall Street Journal here  on stock buybacks. As usual, they ask me not to post the whole thing for 30 days though you can find it ungated if you search. An excerpt:... Buybacks do not automatically make shareholders wealthier. Suppose Company A has 0 cash and a factory worth 0. It ...

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A short oped for the Wall Street Journal here  on stock buybacks. As usual, they ask me not to post the whole thing for 30 days though you can find it ungated if you search. An excerpt:
... Buybacks do not automatically make shareholders wealthier. Suppose Company A has $100 cash and a factory worth $100. It has issued two shares, each worth $100. The company’s shareholders have $200 in wealth.  Imagine the company uses its $100 in cash to buy back one share. Now its shareholders have one share worth $100, and $100 in cash. Their wealth remains the same.
Wouldn’t it be better if the company invested the extra cash? Wasn’t that the point of the tax cut? Perhaps. But maybe this company doesn’t have any ideas worth investing in. Not every company needs to expand at any given moment.
Now suppose Company B has an idea for a profitable new venture that will cost $100 to get going. The most natural move for investors is to invest their $100 in Company B by buying its stock or bonds. With the infusion of cash, Company B can now fund its venture.
 [Left out: The alternative would be for company A to lend the money to company B or to buy its stock. But why are the managers of company A, out of its own ideas, better than its investors at spotting other companies with new projects to invest the stockholders’ money?]
The frequent rise in stock price when companies announce buybacks proves the point. In my example, Company A’s share price stays fixed at $100 when it buys back a share. But suppose before the buyback investors were nervous the company would waste $40 of the $100 cash. Imagine an overpriced merger or excessive executive bonuses. Not every investment is wise! 
The $100, stuck inside Company A, would be valued by the market at $60 and the company’s total value would be $160, or $80 a share. If it spent the $100 to buy back one share, the other share would rise from $80 to $100, the value of its good factory. 
When a company without great ideas repurchases shares, the price of the remaining shares rise. This stock price rise is no gift to shareholders. It is just the market’s recognition that $100 has been saved from inefficient investment.
Full oped in 30 days.

Update: Based on follow up commentary, it's pretty clear than 99% of people do not understand the point: It's not about what companies do with today's profits. The case for buybacks is not that cash must chase investment. The point of the tax cut is the profitability of new investment. Without that, somebody will still just sit on the cash. With that, money will find its way to new investment. Otherwise, we're just putting money from the right pocket to the left pocket. Investment in the end comes when it is profitable, looking forward. Nothing about who gets what part of today's profits has anything to do with it. I will stress this next time! A good learning experience.
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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