Here's a simple topic that is surrounded by myths and mis-conceptions: Stock buy-backs increase stock prices.

This is one of those ideas that contains some truth, but not for the reasons put forward, here are some of the variations you will see:

1. Stock buy-backs reduce the number of shares outstanding increasing earnings per share. To maintain constant PE the price must go up.

2. It shows a company's confidence in the future: they are investing in their own stock.

3. The company believes its stock is undervalued and will soon rise so they are buying it.

and so on.

First, let's address the mechanics of the situation. What is a company worth? Well, on the asset side of the balance sheet it has it's profit-making activities (V) plus any spare cash or liquid investments (C). On the liabilities side it has its debt (D). What is the stock worth in aggregate? S = V + C - D. Notice I am not invoking any valuation method to derive the value of the going concern, simply showing how it figures into the aggregate shareholders' equity.

So when a company pays a dividend or buys back stock it is using C, the cash (or liquid assets) it has over and above what it needs to fund day-to-day operations. With a dividend the effect is easy to see: C decreases so S decreases by an equal amount - this is why the ex-div price is equal to the share price less the dividend per share.

For the share buy-back it is a little more complex. Let's say there are N shares, trading at price P. Let's also agree that the company is going to spend all of its spare cash, C, on the buyback. So it buys back n = C/P shares. What is the stockholders net worth now? The original value of the company less the cash used = S - C = V-D. How many shares are left outstanding? N-n. What should their price be? Pnew = (V-D)/(N-n). Substitute n = C/P and you will see Pnew = P. So all other things being equal, the share price should not change.

How are the two events similar or different? Before the event we have a shareholders who own a company which owns productive assets worth V, cash worth C and owes debt of D. In the case of the dividend payment, after the event we have shareholder who own a company with assets worth V and debt of D, and the shareholders in total have cash of C - the cash has been transferred to the shareholders but their ownership of the company is worth less. In the case of the stock buy-back we have a reduced number of shareholders who own a company with assets worth V and debt of D, and the ex-shareholders who own total cash of C. Notice that the overall net worth of each of the players does not change, only the form of that net worth (a claim on cash and assets vs direct ownership of cash or assets).

The nice thing these days is that the tax consequences are the same for dividends and buy-backs.

So, going back to the points at the beginning of this post.

1. The PE of a company completing a stock buy-back doesn't stay constant. This is because by distributing all the cash, the leverage and hence the risk of the shareholders' investment increases, thus the PE decreases.

2. The idea of a company "investing" in their own stock is a fallacy. A company cannot invest in its own stock, it is meaningless to pay dividends to itself. It is meaningless for a company to buy its own stock, hold it and later sell it for a "profit". Most corporations have authorized but unissued stock that could serve the same purpose without using any cash for the buy-back in the first place. Any company telling you they are doing a stock buy-back to "invest" in their own stock is blowing smoke.

3. Same as above. If management believes their stock is undervalued then they should dig into their own pockets and buy with their own money. They should also do a better job communicating with the market. Neither of these activities uses the shareholders' money.

So why do corporations love to announce stock buy-backs rather than pay a dividend? My guess is that it is self-dealing on the part of management: Markets are not efficient in the short term, so any company buying its stock over a short time frame is going to drive up the stock price, people know this and try to ride it adding to momentum; once you have momentum running it feeds on itself. The bulk of senior management compensation is tied to options and stock grants which naturally do exceedingly well during these run-ups providing insiders with excellent compensation opportunities. When prices drop back down again, they can grant themselves a whole new batch of options at low strike prices. Wash. Rinse. Repeat.

As a final comment, note that as a result of the temporary run-up in stock price caused by a buy-back (or even the announcement of same) the company pays a temporarily inflated price for its shares and thus ends up buying less shares back than if markets were efficient. The remaining shareholders end up with less of the company than they might otherwise. So, distributing money to shareholders via buy-backs seems less efficient than via dividends.