Stock Buybacks 101

Are Buybacks Golden — or Rotten — Eggs?

Stock Buybacks 101
November 4, 2014

A stock buyback refers to a company buying shares of its own stock. This leaves fewer outstanding shares of company stock on the market, which is intended to make the stock more valuable to current stockholders. Companies may do this on the open market, or through an offer to their shareholders (known as a tender offer) to buy back their stock at a certain set price.

As a stockholder, how can you complain about that? You probably don’t need to… but it is important to understand why the company is buying back its stock. The reasons could be good or bad for the long-term health of the company, and there are more potentially bad reasons than good.

The primary positive reason is that the company views its stock as undervalued, and that the best use of its cash is to buy this stock back cheaply and retire it – effectively giving a dividend to shareholders. It is hard to complain about that motive. (Conversely, if the stock is overvalued yet the company is buying it back, that is a sign of trouble.)

Meanwhile, there are a series of underlying motives for stock buybacks that should be viewed more critically:

  • Inflated Earnings per Share – The company has reduced the number of shares, therefore the earnings per share has to go higher if nothing else changes. Increased earnings-per-share has a positive effect on a series of important financial ratios such as the price-to-earnings (P/E) ratio.

    Return on Equity (ROE) is also increased, because there are fewer equity shares. The buyback also reduces assets through the spending of cash on the shares; therefore, return on assets (ROA) appears higher.

    The essence is that all of a company’s fundamentals look better than they really are. Improved numbers are not the result of increased earnings, but from decreased shares. It can be argued that the number of recent buybacks is artificially keeping the current bull market going as companies are under pressure to sustain ever-higher earnings growth.

  • Financed Buybacks – A correlation between a stock buyback and excessive borrowing is not desirable. Financing a stock buyback is essentially doubling-down that the positive perception of the stock after the buyback will increase cash flow and will more than compensate for the interest payments.

    That strategy may work in some cases, but if it does not, your stock is in no better shape and you have less cash cushion to deal with any major setbacks. However, there is a more unpleasant reason you may want to borrow to buy back stock – read on.

  • Takeover Scenarios – A hostile takeover attempt may be staved off by a stock buyback involving considerable borrowing (known as a leveraged buyout). The hope is that the stock price will improve, and that the combination of increased price and significantly higher debt on the books makes the company less attractive to a takeover. (Of course, this may make your stock less attractive to a long-term investor as well.)

  • Stock Options – Employee Stock Option programs (ESOPs) dilute the value of the company’s stock by definition. As an increasing number of stock options are exercised, the number of shares increases and dilutes the value of existing stock – therefore, a company may buy back shares to raise the per-share price and offset the dilution.

So are buybacks golden eggs or rotten ones? To decide fairly requires a fundamental analysis of the reasons for the stock buyback and whether it is being done for artificial reasons. To extend the metaphor: to assess the quality of the eggs properly, you should analyze the goose.

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