Stock Buybacks: Pros And Cons

What Methods Companies Use To Buyback It's Shares?

1. Open Market

This is the most common share repurchase method in the US and it represents around 95% of all buybacks. In this methods, company buy it's shares on the open market like an other investor would at the market price. When a company announces a buyback it is usually perceived by the market as a positive thing, and as a result, stock price goes up.

2. Fixed Price Tender

Up to 1981 all tender offer repurchases were done using a fixed price tender offer. This type of offer have specified purchase price, number of shares and offer duration with public disclosure required. Shareholders decide whether or not they wish to participate. Frequently, officers and directors are not allowed to participate in the tender offer. If the number of shares tendered exceeds the number that they wanted to buy, then company buy shares on pro-rata basis. which means that they buyback same % of stocks form the shareholders based on the number of stocks they own already.

3. Dutch Auction

It was introduced in 1981 and allows an alternative form of tender offer. The first firm to utilize the Dutch auction was Todd Shipyards.[3] A Dutch auction offer specifies a price range within which the shares will finally be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm compiles these responses, and create a demand curve for the stock. The purchase price is the lowest price that allows the firm to buy the number of shares originally wanted.


What Are Pros And Cons Of Stock/Share Buybacks:

Pros:

1. A company that is buying back its own stock usually believes the stock is undervalued and believes it is a good buy. This is a good sign for shareholders because the company is basically betting on their continued success.

2. Stock buybacks create a very nice price support level for investors. This is especially true in recessionary periods or bear market periods. A stock that has a massive stock buybacks will have that extra price support that can serve as a safety net for investors in the stock.

3. Buying back stock means less outstanding shares, which means higher earnings per share number if all other things stay equal. A higher EPS number is always important in the market.

Cons:

1. Serve as an easy cover up for poor financial ratios at the company, because company can buy their own shares and create an artificial lift in their financial ratios which makes market observers believe things are improving, even if they are not.

2. Allow the company insiders to take advantage of stock option programs while not diluting the overall EPS number that is reported to the market. Warren Buffett said several times that he believes employee stock option programs and buyback programs can be quite shady.

3. Typically creates a quick and often artificial jump in the price of a stock. Advantageous insiders then quickly sell at a higher price while individual investors tend to be late buying into the stock and buy in at high price levels.

More about pros and cons of buybacks I'll cover in some futures posts.