Since the company’s operations don’t change, its return on operating capital is the same after the buyback. But the equity is now worth only €1.3 billion — exactly the value of the operations, since there is no cash left. The company’s earnings fall as a result of losing the interest income, but its EPS rises because the number of shares has fallen more than earnings have. The share price remains the same, however, as the total company value has fallen in line with the number of shares. Therefore, the P/E ratio, whose inputs are intrinsic value and EPS, drops to 13.8, from 15. The impact is similar if the company increases debt to buy back more shares.
Why does the P/E ratio decline? In effect, the buyback deconsolidates the company into two distinct entities: an operating company and one that holds cash. The former has a P/E of 13.8; the latter, 33.3 (a cash value of €200 million divided by €6 million of interest income). The P/E ratio of 15 represents a weighted average of the two. Once the excess cash is paid out, the P/E will go down to that of the operating company, since the other entity has ceased to exist. Thus the change of EPS and P/E is a purely mechanical effect that is not linked to fundamental value creation.
Taxes Shield Value from Leverage
When corporate taxes are part of the equation, the company’s value does increase as a result of share buybacks — albeit by a small amount — because its cost of capital falls from having less cash or greater debt. The cost of capital is lower when a company uses some debt for financing, because interest payments are tax deductible while dividends are not. Holding excess cash raises the cost of capital: since interest income is taxable, a company that maintains large cash reserves puts investors at a disadvantage. In general, having too much cash on hand penalizes a company by increasing its cost of financing.
The share price increase from a buyback in theory results purely from the tax benefits of a company’s new capital structure rather than from any underlying operational improvement. In the example, the company incurs a value penalty of €18 million from additional taxes on the income of its cash reserves (assuming €200 million in cash, a 3 percent interest rate, and a 30 percent tax rate, discounted at the cost of equity of 10 percent, and assuming that the amount of cash doesn’t grow and that it is held in perpetuity). A buyback removes this tax penalty and so results in a 1.4 percent rise in the share price. In this case, repurchasing more than 13 percent of the shares results in an increase of less than 2 percent. A similar boost occurs when a company takes on more debt to buy back shares (Exhibit 2).
We can estimate the impact on share prices from this tax effect (Exhibit 3), but historical and recent buyback announcements typically result in a much bigger rise in share price than this analysis indicates. Research from both academics and practitioners consistently finds that companies initiating small repurchase programs see an average increase in their share price of 2 to 3 percent on the day of the announcement; those that undertake larger buybacks, involving around 15 percent or more of the shares, see prices increase by some 16 percent, on average. Other, more subtle reasons explain this larger positive reaction to share buybacks.