4. Stock Valuation

By engaging in a share buyback, managers could signal the market that they believe the shares are undervalued. Because of that undervaluation, repurchasing the shares is relatively cheap. And once the stock price has corrected to the fair value, the firm could sell them again and pocket the difference. Dividend payments do not have this signaling element.

  

This signaling hypothesis appears to play an important role in reality. Unlike the strict assumptions with which we have started this module, there is generally a substantial information asymmetry between managers and external investors. If managers believe the shares are undervalued, it might not suffice to simply hold an analyst conference to share that believe. As talk is relatively cheap, the resulting signal could  have limited credibility. A more credible signal could be to put actual money on the believe and buy back the potentially undervalued securities.

   

The undervaluation hypothesis could also be one of the explanations for why the announcement of share buybacks is generally associated with a positive stock price reaction. Peyer and Vermaelen (2008), among many others, document this for the U.S. and Manconi, Peyer, and Vermaelen (2014) extend it internationally. 

  

In sum:

  • If market participants interpret buyback announcement as a sign of undervaluation, the stock price often experiences a positive abnormal return in the short term. In the medium term:
    • If the stock was actually undervalued, the price will likely remain at the higher level.
    • No wealth transfer takes place if the stock market properly incorporates the undervaluation signal upon the announcement of the program.
    • If firms repurchase shares at a price below the fair value, wealth is transferred from the selling shareholders to the remaining shareholders.
    • If it turns out that the stock was not undervalued, the price will revert to the original level. In this case, there will be a wealth transfer from the remaining shareholders to those who sold the shares back at the higher post-announcement price.
  • If market participants don't consider the buyback a sign of undervaluation, it could still be that the stock price goes up in the short term. The reason is that the firm's buyback activities increases demand for shares and therefore support (or inflate) the stock price. In the medium term, as the firm stops buying, the stock price should revert to the original level. Again, this could result in a wealth transfer from the remaining shareholders to those who sold at times of high demand.
  • Of course, it could also be that the firm repurchases shares at a time of overvaluation (knowingly or unknowingly). The additional demand from the buyback might further support the stock price. Eventually, however, the price should go to its fair value. The result would be a wealth transfer from the remaining shareholders to the selling shareholders.