There are a number of ways in which a company can entice investors to buy their stock. The two most common ways of doing this are share price appreciation and dividends. However, many company executives have turned to financial engineering in the form of share buybacks to increase the company’s share value.
Under a share buyback, a company purchases a certain number of its own shares on the open market. Sometimes they even make a tender offer to existing shareholders at a slight premium to the market price. The company then cancels the purchased shares, reducing the total number outstanding, making each remaining share worth that much more.
The size of the pie is the same, your slice just got bigger
In theory, management only repurchases stock if it expects to enhance shareholder value more that way than by using the cash for capital spending, acquisitions, product development or dividend distributions.
One of the most obvious reasons for the growth of such programs is to help offset the dilutive effects of generous stock compensation packages for employees, including stock options and stock contributions to 401(k) programs. Earnings are “diluted” when the number of shares outstanding increases, reducing per-share earnings.
Benefits of share buybacks
In most countries, taxes on capital gains are lower than dividends, leaving more money in shareholder’s pockets. Using buybacks in order to grant management stock options can improve their performance and may make it easier for the company to hire better managers. Buybacks can boost share price which can benefit short term investors and traders.
Pitfalls of share buybacks
Buybacks artificially increases earnings per share and reduces price to earnings ratio (PE). Reducing the amount of cash on the balance sheet and reducing the number of shares effects other financial ratios. Less cash means higher return on assets (ROA) and less shares increases return on equity (ROE). Increasing share prices and engineering ratios can hide poor performance by management plus increases their compensation package.
Wall Street loves stock repurchases
- Higher share prices equals more commissions
- Higher earnings and lower price to earnings ratio (PE) entice more stock buying
- Buybacks increases the value of stock options, triggering more trading, and more commissions
- Selling tool, the company’s executives feel that their stock price is undervalue, time to buy
Bottom Line: Not all buybacks are equal and some buybacks seem to be nothing more than an attempt to manipulate the stock price.
What are your views on share buybacks?