STOCK BUYBACKS: GOOD, BAD AND THE UGLY

Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

OVERALL GROWTH ISN'T IMPORTANT AS  GROWTH PER SHARE:

Here is an example of ABC Company Inc:

Stock price is  $50 per share. There are 100000 shares outstanding. Market Capitalization is $5.000.000.Profit made this year is 1 million dollars.

So in this example, each share equals .001% of ownership in the company, which is 100% divided by 100000 shares. If the management see that their company (business) will have the same amount of profit this year, like it was last year, that means that their growth rate is 0%. Because the management want to improve the picture and show to shareholders that they are good management, they come up with the idea of stock buybacks. The company use 1 million dollar profit to buy back it's shares on the open market.

After the buyback, as we learned in previous posts, those shares are owned by the ABC Company Inc. and removed form circulation. Now there are only 80000 shares outstanding instead of 100000 that were originally issued.

Average investor (aka shareholder) now no longer have  0.001% of the company, but 0.00125%. In percentage term it is rise of 25% in one year per share!. After the buy back, stock rise will rise in price to 62.50$ from 50.00$! So even though the company made the same amount of profit this year like it did last year, stock price rose 25%!!! Average investors are happy.


WHEN NUMBER OF SHARES OUTSTANDING ARE REDUCED, EACH OF SHARES IS MORE VALUABLE AND MEANS GREATER PERCENTAGE BUSINESS OWNERSHIP:

If a management, like in above example, is in charge, this can lead that amount of shares outstanding goes to 50 or 100. So it good to hold companies like one in the example, buy only if they are fundamentally strong, and hold it in your portfolio as long as they keep doing buybacks. This can increase your profits, but as I said, this destroys companies balance sheet and it's not good long term. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years.


IF MANAGEMENT BUYBACK SHARES AT HIGH PRICES, BUYBACKS ARE NOT A GOOD THING TO DO!

Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually bad if a company pays more for its stock than it is worth or uses money it cannot afford to spend ie. Borrow the money. If the market is overpriced it is bad decision for management to buyback stocks. Instead, the company should put the money into assets that can be easily converted back into cash, to improve liquidity. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit.

There is a saying: "Even the best investment in the world isn't a good investment if you pay too much for it".