So lately you have been following the stock market frenzy over stock buybacks and keep asking yourself “How does this impact my investment strategy?” When you invest in a particular stock, you are expecting returns in two forms: stock price appreciation and dividend payments. Another way investors can acquire wealth from their investments is when a company announces a stock buyback.
What is a Buyback?
A buyback, also known as a “share repurchase”, is when a company buys all or a portion of the outstanding shares in the market. The company is utilizing its own cash in order to acquire shares, thereby reducing the total number of shares outstanding in the marketplace. The next question that arises is why a company would use its own cash to purchase its own shares? Stock buybacks can offer a great tax benefit to corporations similar to dividends. However let us look into some other motives that must be carefully evaluated for decision making.
1. STOCK PRICE APPRECIATION
We all understand how the market is responsible for valuing a stock’s price. A company may feel that its stock price is heavily discounted, and a repurchase would reduce the supply of shares and increase demand, thereby increasing the price of the stock. When the number of owners(stockholders) reduces, the profit is shared among fewer people, in turn providing higher returns to the owners of the company.
For example, in the recent price collapse of Facebook due to reduced earnings, investors were speculating the company would announce a buyback to bring the stock price back up. Reduced earnings was not the only reason for the decline, and issues with European laws had a major role to play. Thus, a buyback move would not have offered a major relief in this scenario. Moreover this strategy would be a questionable method, and my next point will cover this in greater detail.
2. IMPROVED RATIOS
In my previous post to Stock Market Investing – Understanding Indices & Ratios, I discussed the importance of financial ratios in the stock market. So which ratio can you think of that would change with a buyback? If your first thought was Earnings per Share(EPS), you are right. As the number of outstanding shares reduces, naturally the EPS will increase. Correspondingly, the Price to Earnings Ratio(P/E), will also improve. Let us understand with a simple example:
Consider a company X with a current stock price = $20.
Total number of outstanding shares = 4 million
Earnings = $1.6 million
Current EPS = 1.6/4 = $ 0.4
Now let us assume the company announces a buyback of 1 million shares, thereby leaving only 3 million shares outstanding. Keeping the earnings constant, the new EPS after buyback is :
After buyback EPS = 1.6/3 = $ 0.53
The market often considers a lower P/E ratio as a positive sign, indicating an undervalued stock. Let us see the impact of a buyback on the P/E using the same simplified example:
Assume the share price remains at $20
Before buyback P/E = 20/0.4 = 50
After buyback P/E = 20/0.53 = 37.74
As you can see these improved ratios can change the way the market will perceive this stock.
However, before giving in to a repurchase offer, investors must evaluate the motives behind this decision. Improving financial ratios is a questionable motive on the part of the management and calls for caution on the part of investors.
3. STOCK DILUTION
Suppose a company has issued 100 shares to 100 individual shareholders. Each shareholder owns 1% of the company. If the company then issues 100 new shares to 100 more shareholders, each shareholder only own 0.5% of the company. The purpose of dilution is to reduce each investor’s ownership, thereby reducing the voting power.
This is often done when companies offer generous stock options to their employees. Distributing too many shares to selected employees through ESOPs can be a cause for concern, which is where dilution comes in handy.
BUYBACK OFFERED — GO BANANAS ???
As I have repeatedly stated the importance of research and understanding company fundamentals, stock buybacks will also require a thorough analysis before making a decision. Through your research if you realize the company is truly undervalued and a buyback is a great move forward, then this is your time to go bananas! However, if you see no reasons for the stock buyback and realize the management is only trying to manipulate the ratios and in turn increase the stock price, stay away from it.
I hope this post could offer some clarity on the subject of buybacks. I would love to hear your thoughts and if there was anything else I may have overlooked while writing. Thank you for reading.
Be Frugal, Be Smart, Be Rich!