Why is it bad for investors when a company buys back its own stock at a price HIGHER than its intrinsic value?

In: Other

Let’s say you have a company with 10 shares, and each share is $9 each. Your company is worth $90. They earn $10. Now the company is a $90 with $10 in the bank, so the company is worth $100. Each share is worth $10… which is the $9 intrinsic value plus each share owns $1 from that $10.

The company decides to buy back a share at $10. Now we’re down to 9 shares, but the company no longer has $10 in the bank. So now the company is only worth $90, but it’s split 9 ways, so each share is worth $10. Repurchasing shares didn’t actually change the value of each share.

Now let’s say on Monday the shares are $10, on Tuesday they’re $20, and on Wednesday they’re $10 again. And unfortunately the company bought back the shares on Tuesday. So they only bought half a share. So your company spent $10 on half a share. Now there are 9.5 shares (10 original shares minus 1/2) of a $90 company. Split $90 9.5 ways and now your $10 share is worth $9.47. Not the $10 it should be.

There is no such thing as intrinsic value.

Buybacks may, in general, possibly a bad signal for *long-term* investors.

When a company has available cash, it has several options on what to do with it. Part of it generally goes to ensuring liquidity, but let’s set that aside and talk about “extra” cash beyond what you need for ongoing business. There are mostly two things that a company can do with it: reinvest or pay out.

Reinvestment might mean expanding its operations, hiring more people, building new offices, getting new equipment, or a wide variety of other things depending on the industry. Paying out may come in the form of dividends, buybacks, or other mechanisms.

Companies are generally expected to go through various phases of growth and distribution – similar to how you would not expect fruit from a tree early in its growth. If a company starts switching from reinvestment to payouts, that means you should not expect as much growth from it. If you were investing with the hope that the company would grow, that’s bad – but if you want the payout now, then that’s good.

Imagine you and 9 friends decide to form a company. You each put in $10,000 and get 1000 shares. The company has $100,000 in its bank account, there are 10,000 shares. You can figure out each share is worth $10, by dividing amount in the bank account ($100,000) by number of shares (10,000).

Now suppose the company buys back Jimmy’s shares for $11. Then $11,000 will move from the bank account into Jimmy’s pockets. Jimmy’s shares are effectively canceled. So the company now has $89,000 and the 9 remaining owners have a total of 9000 shares. You can figure out each share is worth $9.89, by dividing amount in the bank account ($89,000) by number of shares (10,000).

Basically the extra $1000 Jimmy got was paid for by everybody else.

This company wasn’t doing any actual business, it just had money sitting in a bank account. A real company would have a much more complicated business, and the “intrinsic value” of that business is hard to figure out, it often involves making assumptions.

The money they are using to buy the stock back basically belongs to the shareholders and they are wasting money overpaying for something.