[portent]

Personally I don't understand why a buy-back should increase stock price.

Sure, there are fewer shares - but the value of the company has gone down (it has less free cash, i.e. fewer assets) and the two effects should exactly offset each other.

[valuearb]

One reason is embedded in the valuation, every stock is worth it's future cash flows, discounted for time. Since we can't know the future it's actually forecast future cash flows, and you discount that stomata for risk. A cash dividend eliminates the risk associated with that part of the value, increasing it.

An example would be a stock you value at $10 per share. It has $5 per share of excess cash, but you attribute $3 of value to the cash. This is because you discount 20% for dividend taxes were it to be paid out, and a further 20% for risk it may never be dividended or that it might be invested poorly.

So if the company pays out the actual $5, netting you $4, the remaining shares should still be worth $7 in your valuation estimate, meaning $1 in value is created.

This is of course pedantic, because it can be argued that there should be no risk discount for cash, and if there is certainly not 20%. My argument would be I'd value $1 of cash in Buffett's hands as worth more than $1, and in the hands of many public CEOs hands at less than $1. There is too much self-dealing by public management, and they usually possess little investment expertise outside their own business.

Does Apple have any car development expertise or unique IP? I'd say the risk of them blowing $40B in that market is significant.

So I'd argue that a small risk discount exists in most cases and is recaptured upon dividend.

[mgolawala]

The value of the shares goes up because, even if the business and profitability stays exactly the same, with fewer out standing shares, the earnings per share goes up.

[portent]

Yeah but if you transfer an asset (cash) out of the company, all other things being equal, the value of the shares must go down.

This McKinsey article is old but explores the topic in some detail.

http://www.mckinsey.com/business-functions/strategy-and-corp...

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"Sending signals

The market responds to announcements of buybacks because they offer new information, often called a signal, about a company’s future and hence its share price.

One well-known positive signal in a buyback is that management seems to believe that the stock is undervalued. Executives can enhance this effect by personally purchasing significant numbers of shares, since market participants see them as de facto insiders with privileged information about future earnings and growth prospects. A second positive signal is management’s confidence that the company doesn’t need the cash to cover future commitments such as interest payments and capital expenditures.

But there is a third, negative, signal with a buyback: that the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere. Some managers are reluctant to launch buyback programs for this reason, but the capital market’s mostly positive reaction to such announcements indicates that this signal isn’t an issue in most cases. In fact, the strength of the market’s reaction implies that shareholders often realize that a company has more cash than it can invest long before its management does.

Therefore, the overall positive response to a buyback may well result from investors being relieved that managers aren’t going to spend a company’s cash on inadvisable mergers and acquisitions or on projects with a negative net present value. In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what management will do with excess funds.

Such shareholder skepticism would be well founded. In many industries, management teams have historically allocated cash reserves poorly. The oil industry since 1964 is one example (Exhibit 4): a huge price umbrella for much of this period, courtesy of the Organization of Petroleum Exporting Countries (OPEC), provided oil companies with relatively high margins. Nevertheless, for almost three decades the spread between ROIC and cost of capital for the industry as a whole was negative. Convinced that on a sustained basis the petroleum industry could not deliver a balanced source of income, many companies committed their excess cash to what turned out to be value-destroying acquisitions or other diversification strategies. For example, in the 1970s, Mobil bought retailer Montgomery Ward; Atlantic Richfield purchased Anaconda, a metal and mining company; and Exxon bought a majority stake in Vydec, a company specializing in office automation. All of these cash (or mostly cash) acquisitions resulted in significant losses."

[danans]

If demand for shares is constant during the buyback, then reducing the number of shares via a buyback should send the price up. Which raises the question: Why would marginal demand for shares be independent from cash holdings? Probably because the investors have other reasons for wanting the stock, chief among them being future growth potential.

[xapata]

Regardless, the person who sold shares to the company gets taxed at long-term capital gains rates instead of dividend rates. Much better.

If Icahn started selling shares to someone else, the price would fall. If he sells to Apple itself, much less likely that the price would fall.