The Value of Share Buybacks

Abstract

A formal theory is presented for the valuation of share buybacks. Formulas are given for calculating the equilibrium and effect on shareholder value in different share buyback scenarios. The prevalent belief amongst scholars and practitioners is that share buybacks can substitute for dividend payouts as a way for companies to return capital to shareholders, possibly with a tax benefit to shareholders. This so-called substitution hypothesis is shown both theoretically and empirically to be a fallacy as share buybacks may significantly affect the value to shareholders. This is important because share buybacks are now substantially larger than dividend payouts, possibly as a result of the substitution hypothesis commonly believed to be valid. The presented theory is also applied in several case studies.

Keywords: Share repurchase, valuation, equilibrium, uncertainty