Skip to main content

Realities of Debt Issuance on Stock Price with Stock Buybacks

Say there was a venture that owned a home worth $500k and it was owned free and clear. And this venture created shares in the home, 100k of them. Well logically, each share is worth $5. Now let's say this venture goes to a lender who lends 80% of the home's value so a $400k loan. What happens to the valuation? It stays the same at $500k. The home itself isn't now worth $900k. Equity in the home actually goes down to $100k.

Now, in terms of the share price, it's all about what gets done with that cash. If the cash stays in the venture, you have $400k cash and a $500k home for total assets of $900K. Then you have a new $400k loan as a liability which means $500k in equity since assets = liabilities + equity. Therefore the share price remains $5.

But what happens if that $400k is distributed to investors in the form of dividends? As those distributions are made, the value of the stock should go down since the venture no longer has that cash. Investors are still whole but the venture itself is worth less. Let's say half the cash is distributed to investors. That means each share will get $2 of dividends and the venture is left with $200K cash, $500K home, $400K loan, and $300K of equity. Investors now have $2 of cash and $3/share in the venture so still $5 in total but the venture itself is only worth $3 per share not $5.

How about stock buybacks? Let's say the same amount of cash, $200K, is used to buyback stock. At $5 per share, the venture can buy back 40K shares. 40% of the investors who decide to sell will get $5 cash in exchange for their shares. What remains is $200K cash, $500K home, $400K loan, and $300K equity. What is different is there are now only 60K shares outstanding instead of 100K. So each remaining share is still worth $5. Again investors are made whole with the ones who sold receiving cash while others kept their shares in the company at full value.

In reality, this isn't what happens. First, when a company announces a stock buyback, the market sees this as a major buyer in the market willing to buy the stock at any price so the share price usually pops on the announcement. But this will erode value for those shareholders that don't sell. Let's say the market bids the price up to $5.50 per share on the announcement, a 10% artificial increase in the share price. Now the company can only buy back 36K shares, not 40K. Playing this out, some shareholders that sell will get $5.50 and the shareholders that remain will be left with the same thing: $200K cash, $500K home, $400K home, and $300K equity. But now there are 64K shares remaining, not 60K. $300K/64K = $4.69 share price so value was actually destroyed for remaining shareholders by doing the stock buyback. However, this will take time to materialize because the daily stock price would still show $5.50 per price since there is an active buyer (the company) buying at that price. On top of this, the shareholders feel like the company is creating value with its stock buyback given the pop in the stock price. But eventually, reality will set in on what the company actually has on its balance sheet and what a share is actually worth.

This gets even more distorted when the venture issues shares to employees and buys back stock to neutralize that effect. Let's say the company has one employee and in lieu of a $50K salary, they issue stock options to the employee. Assuming no stock buyback, the company would need to issue 10K new shares at $5/share for that employee's compensation. At the end of the year, there would still be $400K cash, $500K home, $400K loan, and $500K equity. But the company had to issue 10K new shares meaning there are now 110K shares, not 100K, so each share is now worth $4.55, not $5. I'm not against stock options. I am actually a big advocate for creating employee ownership in companies, but the market should not ignore the fact that issuing new shares impacts the value of stocks.

Now what if the company tried to "neutralize" that stock issuance. The stock price should go back to $5, right? Wrong. Let's say there was no pop in price from the stock buyback announcement so shares remained at $5. The company would then need to buy 10K stock for a total of $50K to keep the outstanding shares at 100K. Some investors would sell and get the $5. For the investors that remain, what is left is $350K cash, $500K home, $400K loan, and $450K of equity. 100K shares are outstanding so the stock is now worth only $4.50 per share, even less than the $4.55 if they didn't try to neutralize the impact of issuing new shares. Clearly, this becomes even worse for remaining shareholders if the stock price does pop on the buyback announcement.

Based on these scenarios, there should be no increase in the share price when a company announces stock buybacks so if you see this and you are an existing investor in the company, you may want to consider being one of the sellers since they are the ones that get more value at the end of the day. Of course, if the home increases in value over time from $500K, and there are fewer shares outstanding, then the remaining shareholders could quickly make up for the value erosion from the buyback and eventually their stock will be worth more than the shareholders that sold earlier. But this exercise was only to look at the realities of what has been happening as companies go deeper into debt and using that cash to buyback stock. I have a hunch that stock prices have been artificially inflated with some of that caused by companies being buyers of their own stock at any value. This means that existing shareholder value has actually been eroded and we are likely entering a phase in the stock market where those realities are setting in.