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