Impact of Share Buyback

LevFinGS:

I'm confused with your question. But I think it's the fact that equity is BOOK VALUE that is stemming your question.

ROE = Net Income/Equity - so if ROE is 250,000/1,000,000 = 25% and then you use $250,000 to buy back shares, your equity decreases by the cash used to buy back shares. So your new equity is 750,000 and your new ROE is 250,000/750,000 = 33%.

Your BV of equity is not impacted by market price, so the increase in market price not reflected at all in equation.

I think my question was a little unclear in terms of perspective. I am trying to look at this from the firms perspective. Are you sure the book value would decrease by the nominal cash used? Wouldn't it be by the par value associated with a single share? For example, if my share par value was $100 but the stock was trading at $1000, i would only be able to purchase 250 shares. This would decrease the book value by only 250*100=$2500. Right?

Ashpy:

Bernank - that's not correct. The book value goes down by the total amount spent on the buyback - this is where bv vs mv usually gets confusing. The credit in your example is $250k to cash, and the debit is 250k to equity. That's why you sometimes see companies with a huge negative Tstock balance - its because the balance reflects current market prices, while the initial common stock and apic balances reflect the issuance price.

So there are two ways to answer your q:

from a BV perspective, levfings is exactly correct - it should be pretty clear that ROE goes up as NI is divided by a now far lower shareholders' equity (assuming the incremental interest expense or lost interest income impact on net income isn't significant).

From a MV perspective the question is a little different, and more interesting. When a company uses its cash to give back $ to investors, it is essentially saying "this is the best use of our cash". In other words, either because we think the stock is currently undervalued (good sign) or because we dont have any good investment opportunities as a firm (bad sign) a buyback is the best thing we can do. How the market reacts to that (i.e. whether the shares go up or down) is what will determine the market driven ROE.

So with this line of thought...you could technically have a firm with either zero or negative shareholder's equity? In which case ROE or ROC would be completely meaningless?

Thanks for the input.

$6.67

jgx101:

$6.67

Follow up question: so why, in real life, share price for Company A only goes up to $5.5?

Knowing nothing else I'd guess $5.75 so +15%.

25% of shs outstanding is pretty hefty and most companies tend to do this over a few years whenever they announce something like this. I'd guess 3 years as extremely aggressive and 5 years as aggressive. During this time they also usually issue more shares. Although they increase EPS this way through reduced share count, they could be using the money towards other opportunities if they were present.

But the answer they're expecting is probably 0

don't you need EPS for this? you get the current P/E ratio, assume it to be held constant, and then multiply by the new EPS to get the price.

FundofFun:

don't you need EPS for this? you get the current P/E ratio, assume it to be held constant, and then multiply by the new EPS to get the price.

That's what I thought as well. But interviewer apparently thinks there's some other way to figure this out...

I think you guys forgot to account for the cash they are spending. New price= (2005-50new price)/150= 6.67 -1/3*new price = 5. Share price will go up or down whether the market thinks it was a good decision or not.

jaymo:

I think you guys forgot to account for the cash they are spending. New price= (200*5-50*new price)/150= 6.67 -1/3*new price = 5. Share price will go up or down whether the market thinks it was a good decision or not.

Spending cash to buy back shares does not show up on income statement. EPS will go up because shares outstanding are reduced now. P/E should remain the same, so the new share price should equal EPS(new) times P/E ratio. Though I think using EPS isn't very accurate since we should probably take out interest income/expenses. Any thoughts?

Classic WSO thread, first answer is correct and then every college junior and summer intern jumps in with absolute stupidity

I'll try to answer this as far as I understand it. Someone please correct me where I am wrong.

It is my understanding that there are a few separate types of Share Repurchase methods.

There is the Open Market repurchase method, whereby a firm is able to repurchase shares of their stock in the market without announcing it to the public. The mechanics of this are that market conditions dictate whether, when, and how much a firm seeks to repurchase. This process can span several days to several months. The firm is limited in the amount that they can buy back daily based on the ADTV (average daily traded volume), where they can only repurchase x% (e.g. 10-25%, based on other constraints) of the average traded volume.

The next type is a tender offer, where a company designates a specific amount of cash to be used for share repo and presents a range they'd be willing to repurchase stocks at (e.g. between 55-60). Then shareholders are presented with this offer and have the option to sell back their block of shares at a specified price. It is up to the firm to determine the optimal amount of share to repurchase, at the cheapest price, to come up with the most appropriate blend.

Then there is an Accelerated Share Repurchase program. This occurs when a company hires an Investment Bank to go out into the market and repurchase their shares, paying a premium to the bank for their services. Basically, the firm gives the bank money (e.g. $1B) and says "please buy back as many of our shares as you can." In this method, the risk is transferred to the investment bank, and in turn, the firm pays a premium to the bank. The bank essentially borrows the shares from clients/institutional investors, then sold back to the firm. i.e. The bank just uses the cash given to them to pay for the shares they're 'borrowing', and gives them back to the firm in the open market. This method is usually the fastest method, and allows for greater freedom in repurchasing stocks (i THINK).

There are a couple rules that the SEC has enacted. I'm not too familiar with all of them. For example, though, corporations have blackout periods whereby they aren't allowed to repurchase shares due to the issue of insider trading. These sorts of blackout periods are usually around earnings releases and things like that. However, there is SEC rule 10b5-1, which allows the Investment Bank in an accelerated share repo to repurchase shares even during blackout periods.

There's another rule, rule 10b-18: The rule breaks down as follows: Manner of purchase: The issuer or affiliate must purchase all shares from a single broker or deal during a single day. Timing: An issuer with an average trading volume less than $1 million per day or a public float value below $150 million is unable to trade within the last 30 minutes of trading. Companies with higher average-trading-volume or public float value can trade up until the last 10 minutes. Price: The issuer must repurchase at a price that does not exceed the highest independent bid or the last transaction price quoted. Volume: The issuer can't purchase more than 25% of the average daily volume.

Hope this helps. Again, I'm not 100% sure on this but I worked on share repo models over the summer at my internship so most of this should be right.

cheers

(13x-9x)/9x= 4/9 = .44

when you buy stock for x amount of €€ at 9/share, you consumed 9x/s in cash and thus reduced book value by 9x/s hence the -9x. at the same you added 13*x/share to book value thus the added value is x(13-9). dividing by 9x is just to get a %

Thanks for your replies! Just to clarify, I understand intuitively why book value should increase when the share repurchase price is less than book value per share, but from an accounting perspective, why is this the case? What kind of journal entry would be involved?

I was thinking something like this: Dr. Treasury Shares 13 (contra-equity account) Cr. Cash 9 Cr. Common Stock 4

But I'm not sure if it makes sense that attribute the remaining $4 per share to common stock? Or is it credited to retained earnings?