TIL share buybacks increase shareholder equity

Today, I got a hate comment on my “Rana Foroohar is an idiot and a tool” (which she is). Here it is:

“Hey dumbass – why would the company valuation go down if they do a buyback? Buying back 20 shares out of 100 doesn’t make the company now worth 80, it’s still worth 100, less cash (-20) less shareholder equity (+20). You are not qualified to invest your own money let alone comment on how others should invest. You have zero foundation in finance or economics. Sad dude.”

You know all those cowards who decide to post “anonymously”? Our friend here is one of those. Not only does he take the liberty to insult me, he doesn’t even have the courage to even use a pseudonym. The next step would be to post using the Tor network and tag himself “giant pussy.”

That being said, I can’t believe someone could have such a flimsy grasp of even the most basic corporate finance concepts. We’re not talking and tough amortization schedules or recondite tax deferral laws here: we’re talking about shareholder equity and, apparently, already, this is too much for you.

No, shareholder equity does not go up with a share buyback, anonymous. In fact, the example you cite makes no sense at all.

“Buying back 20 shares out of 100 doesn’t make the company now worth $80: it’s still worth $100, less cash (-$20) less shareholder equity ($20) = $100.”

Note: I re-edited what this guy wrote because it took three readings to get what he wanted.

So our little anonymous friend here pretty much believes in magical dollars. Basically, he claims that whenever a company gives money to shareholder, the value of a company doesn’t change. In other words, a company could be worth $500, give $100 to shareholders and still be worth $500. So… Why wouldn’t the company just give free money to shareholders all the time, then? Why wouldn’t a company give $100 per share every day, or $1,000 per share every day?

Really… How can someone be that stupid? I mean, really? The company is supposed to just invent money  and hand it to shareholders for free? Yes, I know most companies earn profits annually, but those profits are already anticipated and already priced in the company’s value.

Then, he has the nerve to mention “shareholder equity.” Let us assume “shareholder equity” is relevant (it is not). Shareholder equity is simply defined as:

Total assets minus  total passive.

In other words, we, using some random asset valuation method (how do you value patent? Key employees? Or even inventories), evaluate the value of all assets and passive. Then, we substract the passive from the assets and we obtain the magical concept of “shareholder value” which is pretty much as meaningful as drawing The Tower from a set of Tarot Cards.

Let’s assume all assets are liquidated at their book value (a stupid assumption, many assets are totally illiquid and plain and simply unsellable, others will only sell at a tiny fraction of their book value) and let’s assume all debts are paid off right now (another stupid assumptions, some debts simply cannot be paid until their expiration or include huge penalties for early repayment) to get to the shareholder equity.Again, this makes little to no sense because if the firm was indeed liquidated, your odds as a shareholder to get paid pretty much anything are close to 0, assets or not, but let’s follow the accounting logic for a moment. Let me make it simply for you:

SE = A - B 

where:

SE= Shareholder Equity

A = Total assets

B= Total liabilities

Now, let’s assume the company does a share buyback. In order to buy back shares, it either has to:

1. Borrow some money, which increases B
2. Use some of its cash, which decreases A

Even someone who has been run over by a train should see that in the equation “SE= A-B,” if you increase B or decrease A, then SE will go down. It doesn’t take five years of studying corporate finance to understand  that spending money does indeed decreases Shareholder equity, at least on an accounting basis.

That being said, if the company repurchased its stock at a price below its fair value, then metrics should improve, and A’s stock price should go up “naturally.” Let me explain:

Say AAPL is trading at $100 per share. There are 500 shares outstanding and the company earns $10,000 in net profits, so for a $20 EPS. AAPL is thus trading at a P/E ratio of 5 (Price/Earnings = $100/$20 = 5). AAPL has $15,000 in debt and $25,000 cash. Its other assets are valued at $50,000.

AAPL’s shareholder equity is thus : $50,000+$25,000-$15,000=$60,000.

AAPL buys back 100 shares using cash on hand at $100 per share, for a grand total of $10,000.

AAPL’s shareholder equity is thus: $50,000+$15,000-$15,000 = $50,000, a decrease of $10,000

However, there are now only 400 shares outstanding and the company is still earning $10,000 in net profits per year. With 400 shares outstanding, the EPS is now $25. If we assume the P/E ratio is to remain stable at 5, each share is now worth $125 and, thus, the buyback has increased the price of the share from $100 to $125.

But let’s go further. Let’s assume the P/E was unfairly judged by the market, that it should be at 10 and not 5. Eventually, if the market is efficient and things are not rigged, AAPL’s share value should converge to that value of 10. Before the buyback with a $20 EPS, that would have mean AAPL would be trading at $200. After the buyback with an EPS of $25, that would have mean AAPL would be trading at $250.  So the buyback has increased the price of the share from $200 to $250.

Let’s assume the stock was overvalued when AAPL bought it back. Let’s say it should have been trading at a P/E ratio of 3 instead. Before the buyback with a $20 EPS, that would have mean AAPL would be trading at $60, but it was trading at $100 instead. After the buyback with an EPS of $25, that would have mean AAPL would be trading at $75.  So assuming the value of the stock converges to its true trading value, the stock has fallen from $100 to $75 - but the buyback has still prevented the stock to fall to $60. Still, it is considered a bad move because the company could have “waited” to buy back it stocks; it could have waited until the stock fell to $60 to do the buyback, which would have allowed the company to buy more shares (166 instead of 100) for the same price.

Had Apple done that and managed to grab 166 shares at $60 and assuming the P/E converges to the same 3, then Apple would have settled at $89.82, thus increasing the price from $60 to $89.82.

The example above is grossly simplified (it totally ignores liquidity, taxes, fees, etc.), of course, but the basic elements behind it are correct. It goes without saying that a company will do a share buyback when it believes its stock price is too low. In fact, most buybacks are done when a company is pretty much certain its stock is too low.

In other words, having shares of a company doing a buyback is like having a bigger slice of a smaller pie; instead of owning 0.001% of a company worth $100M, for example, you own 0.00125% of a company worth $80M. At the end of the day, you still have that same $1,000 invested.

One day, I will write an entire article on share buyback so people who still believe shareholder equity is relevant (when it comes to valuing at company) can get better informed. Buying back also has a negative effect on market value (meaning the total value of the company according to the stock market) BUT the price of a share should go up. In practice, buying back share often ends up increasing both the market value and the price of shares because:

• a) Investors grossly underestimate the importance of cash and assume the company is keeping money because it ran out of ideas of what to do with it
• b) Interest rates are low and there is an financial advantage in borrowing to buy back shares
• c) It sends a message that the company believes its share are too low.

It shouldn’t work like that and share buyback should have a nil effect as stocks should be fairly valued at all times, but Wall Street has decided not to work like that. In other

Let me clarify that: Let’s say AAPL was fairly valued at $100. In that case, buying back stock shouldn’t create a return above what the market offers because everyone will anticipate that the price will go up due to the buyback and refuse to sell their shares during the buyback, waiting for a higher price instead. Thus, the stock will slowly drift up as people sell at $101, $102 and so on. Let’s take my example above and let’s say you have AAPL shares: would you sell your shares at $100 when they should in theory rise to $125 by the time the buyback is over? If you think AAPL will still fall, perhaps, but that’s already priced in the company’s value before the buyback is announced. If AAPL a good investment before the buyback is announced, then it’s also a good investment after the buyback is announced. Based on that theory, investors should ask for a higher and higher price as the buyback is under way, eventually asking for a price that takes in consideration how many shares AAPL will be able to rebuy assuming the stock price is higher (in other words, with $10,000, AAPL might only be able to buy back 90 shares instead of 100).

Some companies avoid that problem altogether with a Dutch auction share buyback which (kind of) solves that problem.

Still, no, a buyback does not increase shareholder equity. It often increases shareholder value and I absolutely love share buybacks to death, but no, it doesn’t increase shareholder equity. The money spent to buy back shares is gone - poof, vanished, gone.

Next time, before you call someone a dumbass, at least try to be factually correct in your remark.