Share Buybacks – What Are Share Buybacks?
Share buybacks are simple to understand. A company repurchases its own shares which in effect concentrates the number of shares remaining.
The question becomes is there a net effect on investors? The answer is a two-fold answer. First the positive answer.
Share buybacks are one way corporations put their cash to work for shareholders. As mentioned above, they concentrate shares which are supposed to mean each existing share becomes more valuable.
Given fewer shares are in the float, another way to say supply of shares, the stock price should rise as a result. As you might expect, buybacks also benefit valuation measures.
They increase earnings per share (EPS) and therefore decrease the price to earnings (P/E) ratio. Pay attention to the S part of earnings per share and the E part of the price earnings ratio.
You have to understand that a buyback reduces the “S” part of the equation rather than increasing the “E” part of the equation. During times of slow growth, share buybacks can influence key metrics.
Without traversing an entire balance sheet or profit and loss statement, consider the fact that share buybacks also raise Return on Assets (ROA) and Return on Equity (ROE). That may look good but the counterpart is they reduce a company’s cash on hand, an asset, and decrease outstanding equity.
Boards of Directors are like politicians. They want to look good. They are not above using gimmicks and tricks to do so. They do the share buybacks to make it the de facto use of excess cash.
Could they have employed the excess cash in a better manner? That is a yes and no answer. Maybe they could have increased the dividend. Maybe they could have expanded or acquired other companies or increased research and development or maybe they could have paid off debt.
All of these actions could have been more beneficial to the shareholders rather than the share buybacks. It obviously depends on the point in time this buy back occurred. The company may have been sitting on a pile of cash.
As this article is written that is the state of affairs cash wise with US corporations. The real answer to the buyback questions come down to why the share buyback was initiated. If it was initiated as a PR gesture to show false confidence to Wall Street or create a short term rally in the stock or an attempt to offset dilution from prior offerings or executive compensation the end result is almost always detrimental to investors.
The hidden snake in this pile of cash is something called opportunity cost. If share buybacks was truly not the best way to have deployed that cash pile than the opportunity cost of foregoing a more productive method becomes a real thorn that must be addressed.
Studies have learned this opportunity cost causes the problems it causes because shares are almost always bought back during bull markets rather than during bear markets. It seems management falls prey to the same delusions individual investors are subject.
You would think corporate managers would have a better finger on the pulse of the market. But, they do not. Had they waited and pursued their share buybacks in a declining market they would have received more bang for their buck.
If you are holding shares of a company that has announced share buybacks, take a strong look at any profit you have sitting there in the way of share appreciation. It may be a good idea to sell now and repurchase after the share buybacks.
Share buybacks present a unique way to play the market given the history of management’s buy high only to see the price decline. This should not be your only strategy but it may be one you wish to investigate.
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