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The Truth About Stock Buybacks

The Truth About Stock Buyback's
A stock buyback is a company's plan to buy back its own shares. Buybacks are carried out in one of two ways:

1) Shareholders are presented a tender offer with which they have the option to submit (or tender) a portion or all of their shares within a certain time frame.  This is usually at a price higher than the current market level. 

2) Companies can buy shares on the open market over a longterm period. This buyback reduces the number of shares available on the open market.  For the most part an announcement for a share buyback is considered good news for shareholders.  Keep in mind that there are many different reasons a company might want to repurchase shares and do not assume that all buybacks are positive. 

When the market is bad stock prices are depressed and earnings multiples tend to be lower.  If a stock has been hit hard and falls below what it should be worth an investment in the stock could give a better return than any other opportunity facing the company. This is especially true if a company has a ton of cash on hand because cash typically earns less than 23% interest. Another good reason to buy back shares is to defend against takeover bids or use them to buy other companies. 

Another reason a company might do a buyback is to prop up its share price and other financials. This approach is more questionable if the reasoning is just for making financial ratios look better.  Plowing extra cash back into stocks reduces outstanding shares and also reduces the assets on the balance sheet because cash is an asset. Thus the return on assets (ROA) will increase because the assets are reduced and return on equity (ROE) increases because there is less outstanding equity. Another example would be suppose a company's earnings are identical before and after a share repurchase. The earnings per share (P/E) would look better even though the earnings did not improve. The same income with fewer shares outstanding equals a lower P/E.  

An additional reason for a buyback is to reduce dilution caused by employee stock option plans. Companies that handed out stock options to employees like water during the big bull market of the late 90s took it on the chin back then when those options were exercised. Every option that is exercised increases outstanding shares and reduces EPS. 

Buyback programs are sometimes nothing but a marketing ploy.  The average investor hears that a company has announced a buyback program and they immediately get excited.  They buy the stock trying to get in and get a better price than the company will get.  The truth is just because they announce a buyback does not mean that they are obligated to buy back shares. Announcements are often worded like A buyback of up to X million shares over the next X number of years.  The company has no legal obligation to carry out that pledge. 

If a stock is undervalued the buyback positive however be cautious if a company is merely using buybacks to prop up its ratios or get out from under excessive stock option grants. The next time you hear news of a buyback and a stock jumps on the news do not be in a rush to jump on board.  The professionals will short the reaction high because they know the buyback could be months or even years away if carried out at all.

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