ShmoopTube

00:00

And finance allah shmoop why do companies buy back their

00:05

own stock Well sometimes wall street simply gets it wrong

00:09

Investors place of value on a company based on whatever

00:12

price its stock is trading at and when investors do

00:15

get it wrong on the low side cos they're usually

00:18

the first to realize the disconnect and they're usually wise

00:21

to proactively take advantage of it in buying back their

00:24

own stock That's the basic quick and dirty But the

00:26

details answer for why companies buy back their own stocks

00:29

a bit more complex companies who have excess cash used

00:32

to just pay a dividend and when they still had

00:35

more cash than they needed for upgrading those smelting plants

00:38

and improving their assembly line efficiency and perfecting the quality

00:42

of their pooper scoopers while they simply up to their

00:45

dividend But then tax laws changed Basically tax rates went

00:48

higher Acme hemorrhoid cream supply company makes a billion dollars

00:52

in operating profit a year and it pays three hundred

00:54

million bucks in taxes to net seven hundred million dollars

00:58

in earnings but then pays three hundred million dollars in

01:00

dividends back to shareholders but then shareholders pay tax on

01:04

that three hundred million well in california for example shareholders

01:07

would pay something like one hundred million dollars in taxes

01:10

on those three hundred million in dividend distributions so the

01:13

company just earned a billion box and four hundred million

01:16

of it went back to the government well eventually companies

01:20

and individuals got sick of such a heavy tax burden

01:23

So instead of paying out taxable dividends companies began using

01:27

that excess cash to buy back their own stock Instead

01:30

buy backs are not taxed so that entire three hundred

01:33

million dollars that might have gone out for dividends had

01:36

the company used it all for buybacks would be some

01:38

thirty percent more efficient Keep in mind that buying back

01:42

stock shrinks the pie of ownership That is if a

01:45

company has two hundred fifty million shares outstanding and earned

01:48

five hundred million bucks in a year each year for

01:51

five years But each year the company bought back ten

01:54

million shares than at the end of those five years

01:57

The company would have just two hundred million shares out

02:00

standing while still earning the same five hundred million bucks

02:03

Initially the company was earning two dollars a share about

02:06

with fewer shares that two dollars per share grew to

02:09

fifty a share So even on flat earnings the company

02:12

was able to grow its earnings per share just by

02:15

buying back its own stock So yeah all of this

02:18

is nice and can work well if the company trades

02:20

at a low price to earnings Multiple low means that

02:24

the company believes it will be around for the next

02:26

fifty years or so It earns a dollar share and

02:29

trades for ten dollars a share and has no debt

02:31

and is growing revenue steadily it in a five six

02:33

seven Eight percent a year and lives in an industry

02:36

which this year for some stupid reason is out of

02:38

favor with young wall street investors So the stock which

02:41

used to trade a twenty five times earnings now trades

02:44

at only ten times and with the company believing it'll

02:46

still grow earning sizably in the future at ten times

02:50

this year's earnings nine times next years and eight times

02:52

the following year's earnings the company looks like a bargain

02:55

if the's low multiples So let's say a company has

02:58

no cash and no debt and will earn a dollars

03:00

Share this year in trades for ten bucks a share

03:03

Well if it took half of its earnings to buy

03:06

back stock and if the stock price stated ten bucks

03:08

and the earning stayed flat at a buck a share

03:11

well they'd have fought back the entire company in twenty

03:14

years In reality with fewer shares and even just flat

03:17

earnings i'ii earnings that aren't growing a company's stock price

03:20

would almost always go up So in a sense this

03:22

is a way for a company to force ah higher

03:24

stock price or force wall street to recognize its value

03:28

So all of this is great In theory the reality

03:31

is that many companies think they're better than they really

03:33

are and spend billions buying back their own stock at

03:36

twenty bucks a share after it fell from eighty on

03:39

ly to see the stock Ten bucks a share two

03:41

years later the wall street pros do nothing all day

03:44

over even figure out the trends that shaped stock prices

03:46

in the future So it's a rare company that can

03:48

see that vision more clearly than the droves of professional

03:52

investors all around him of course there's a second possibility

03:55

Maybe a company just has a sentimental attachment to its 00:03:58.453 --> [endTime] stock and the missing reunited And it feels good

Full Transcript