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Intel (NASDAQ:INTC) is issuing debt to buy back shares. The share price is jumping. Reuters reports:

Intel Corp shares jumped more than 2 percent on Tuesday as the top chipmaker sold $6 billion in bonds to fund stock buybacks and other business activities.

The initial jump has been maintained, as the following chart shows:

INTC Chart

Why do shareholders keep falling for the oldest trick in the book - share buybacks? Share buybacks do not add to enterprise value. This is a straightforward corporate finance exercise. I will try to explain this with a case example, see below.

Let's say a company has 100 shares outstanding. Each share costs $100. The company has $20 in cash per share and $1,000 in debt. Let's consider two scenarios. In one, the company buys back 10 shares using cash. In another, it uses debt to buy back the 10 shares. In either case, should the price of each share change?

The answer is, of course not. Let's do the math.

What's the total enterprise value of the company before share purchases? It is 100 shares at $100 each, or $10,000. The company also has $2,000 in cash in hand. Adjusting for debt, then, net cash is $1,000. So, the equity value of the company is $10,000 - $1,000 = $9,000, or $90 per share.

In case 1, the company uses $1,000 in cash to buy back shares. So, now net cash is $0, as the remaining $1,000 in cash is exactly balanced by the $1,000 in debt. So, the total enterprise value of the company is now just equal to its equity value, or $9,000. Since there are now 90 shares outstanding, price per share should be $100, same as before.

What happens if the company uses debt instead, in Case 2? Well, net cash is again $0 as incremental debt of $1,000 to buy back 10 shares at $100 each eats up the net cash in hand of $1,000, so the same logic as in Case 1 applies, and the share price remains unchanged.

Now, one may make the argument that the company is changing its capital structure in the second case, as interest from debt is tax deductible, so the net income should increase. Well, not quite.

In case 1, the company gets lower pre-tax income as it uses up cash in hand to buy back stocks and doesn't get to collect interest on the spent cash. In case 2, the pre-tax income is unchanged but is then lowered by the interest on the incremental debt before taxes are assessed. The two cases exactly balance out each other. There is no difference between using cash to buy back stocks and using debt to buy back stocks, assuming the interest rate is the same in both cases.

So, bottom line, stock buybacks are a gimmick. Technology companies have long engaged in stock buybacks, as they used that stock to pay for stock options exercised by employees. It is simply a roundabout - and in my opinion highly inefficient - way of paying employees. It had nothing to do with increasing enterprise value. Retail investors however would cheer as they believed stock buybacks somehow increased the value of each share, and hence its price. Well, as I showed before, it never did, as that is a mathematical impossibility.

There is one exception to the rule, however. If the stock pays a dividend, then by buying back shares the company can actually stop paying dividends, that's a net gain to the remaining shareholders. In other words, if the cost of equity is far lower than the cost of debt, then it makes sense to buy back shares by issuing debt or using cash at hand. But that has nothing to do with the actual share price. The argument applies when the share price is (supposedly) either undervalued, rightly valued, or overvalued.

So why do companies announce share buybacks when the stock is depressed? Surely they are not adjusting their capital structure here, and trading equity for debt to get to a lower WACC (weighted averaged cost of capital). They are just engaging in showboating and sending a message that they consider the share undervalued. However, informed investors shouldn't fall for this share buyback gimmick in any way, like the one going on right now at Intel.

The market seems to bear this out. Intel buys back shares every quarter. According to the company:

2012 Buybacks

QuarterShares Purchased
(M Shares)
$Millions
Q3461,165
Q2411,100
Q1571,500

2011 Buybacks

QuarterShares Purchased
(M Shares)
$Millions
Q41744,133
Q31864,000
Q2932,000
Q11894,000

2010 Buybacks

QuarterShares Purchased
(M Shares)
$Millions
Q4701,500
Q300
Q200
Q10

0

In the mean time, the stock has floundered.

INTC Chart

If someone wants to invest in Intel because he/she believes the company has strong fundamentals, that's absolutely the right thing to do. However, share buybacks cannot be a good reason to invest. As shown above, that doesn't increase the value per share one bit.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice. I am merely stating what I personally plan to do for my own portfolio.

Source: Smart Investors Should Ignore The Gimmick Of Intel Share Buybacks