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".

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.

Stock Buybacks: What Is It And Why It's Done?

What Do We Mean By Stock Or Share Buybacks?

A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the general public. We already know two most common ways in which company return value to the shareholders, and these are stock appreciation and dividends. The third one is stock buyback. When company buy its own shares, because it can not act as its own shareholder, these shares are owned by the company and the number of shares outstanding is reduced by that amount. As a result, every shareholder of the company now has larger % share in the company, and also has a larger EPS or earnings per share (we'll talk about meaning of that in later posts).

Why Would Company Buyback It's Own Shares?

When company make profit, it has two options: pay that money to its shareholders or reinvest it in the business. Usually, company do both, pay some dividend and keep rest of the profit as a retain earnings. But, there are times when management of a company do not see good opportunity to invest, or their main business is non worth investing in. Example is Berkshire Hathaway company. Their chairman, now investment legend Warren Buffett, used companies profits and cash flow from textile business to acquire shares in other companies, because he realized that textile industry was with low profit margins and that that had strong competition from China.

1st. Reason:

So when there are no other better options to put money to good use, last option is share repurchase or stock buyback. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of shares held by the public (also known as a float) means that even if profits are the same, earnings per share will increase. Also, if company's share price is undervalued or depressed, share buybacks will improve return on investments.

2nd. Reason:

Other aspect of stock repurchases is this: if a company's management see that it's stock price is low, or that it is lower than actual book value (more about that in future posts) and currently trading below its intrinsic value, they will consider repurchases.

 3rd. Reason:

Another reason why management prefer share buybacks is that because their compensation is often tied to their ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. It is important to understand that increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.

4th. Reason:

Share repurchases avoid the accumulation of excessive amounts of cash in the corporation, because companies with strong cash generation will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition (also known as Leveraged buybacks - LBO). Anti-takeover strategies therefore often include maintaining a low cash position and the share repurchases increase stock price which makes a takeover more expensive.

5th. Reason:

Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation.

In latter post I'll cover pros and cons of stock buybacks.