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Management article
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Reference no. R0104K
Authors: Justin Pettit
Published by: Harvard Business Publishing
Published in: "Harvard Business Review", 2001

Abstract

Contrary to popular wisdom, buybacks don''t create value by raising earnings per share. But they do indeed create value, and in two very different ways. First, a buyback sends signals about the company''s prospects to the market--hopefully, that prospects are so good that the best investment managers can make right now is in their own company. But investors won''t see it that way if other, negative, signals are coming from the company, and it''s rarely a good idea for companies in high- growth industries, where investors expect that money to be spent pursuing new opportunities. Second, when financed as a debt issue, a buyback is essentially an exchange of equity for debt, conferring the traditional benefits of leverage--a tax shield and a discipline for managers. For such a buyback to make sense, a company would need to have taxable profits in need of shielding, of course, and be able to predict its future cash flows fairly accurately. Justin Pettit has found that managers routinely underestimate how many shares they need to buy to send a credible signal to the markets, and he offers a way to calculate that number. He also goes through the iterative steps involved in working out how many shares must be purchased to reach a target level of debt. Then he takes a look at the advantages and disadvantages of the three most common ways that companies make the actual purchases--open-market purchases, fixed-price tender offers, and auction-based tender offers. When a company''s performance is lagging, a share buyback can look attractive. Unfortunately, a buyback can backfire--unless executives understand why, when, and how to use this powerful and risky tool.

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Abstract

Contrary to popular wisdom, buybacks don''t create value by raising earnings per share. But they do indeed create value, and in two very different ways. First, a buyback sends signals about the company''s prospects to the market--hopefully, that prospects are so good that the best investment managers can make right now is in their own company. But investors won''t see it that way if other, negative, signals are coming from the company, and it''s rarely a good idea for companies in high- growth industries, where investors expect that money to be spent pursuing new opportunities. Second, when financed as a debt issue, a buyback is essentially an exchange of equity for debt, conferring the traditional benefits of leverage--a tax shield and a discipline for managers. For such a buyback to make sense, a company would need to have taxable profits in need of shielding, of course, and be able to predict its future cash flows fairly accurately. Justin Pettit has found that managers routinely underestimate how many shares they need to buy to send a credible signal to the markets, and he offers a way to calculate that number. He also goes through the iterative steps involved in working out how many shares must be purchased to reach a target level of debt. Then he takes a look at the advantages and disadvantages of the three most common ways that companies make the actual purchases--open-market purchases, fixed-price tender offers, and auction-based tender offers. When a company''s performance is lagging, a share buyback can look attractive. Unfortunately, a buyback can backfire--unless executives understand why, when, and how to use this powerful and risky tool.

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