Question

Nestle recently announced a share buyback program. In its press release (see below), Nestle states that ‘share buybacks offer a viable option to create shareholder value.”

Do stock buybacks create shareholder value? Explain your answer from a residual operating earnings (ReOI) perspective.

Answer 1

On an overall firm basis the buybacks or share repurchases do not create any shareholder value as it is the equity that is being used to buy back the shares. If the company buys shares using cash, the same amount is deducted from the equity value and hence net gain or loss is always zero. However since the buyback price is not always perfect and is not in sync with the book value of equity, buybacks can create value given a price where reduction in equity charge is significant.

Residual operating income is the operating income minus Equity charge, where equity charge is equity value multiplied by equity cost of capital. Now due to a buyback, when cash is paid to shareholders who sell their shares, the equity value is decreased. A decrease in equity value leads to a decreased equity charge. If the decrease is more than the decrease in operating income due to decreased equity, then it may create a positive value to remaining shareholders.