The Lowdown On Stock Buybacks
Posted on 12.19.06 by StockPK Team @ 11:29 am
When times are tough in the market, companies will often announce stock buyback programs. Why would a company want to buy back its own shares? What does this mean for shareholders?
Buyback Basics
A stock buyback, also known as a “share repurchase”, is a company’s plan to buy back its own shares from the marketplace. You can think of a buyback as a company investing in itself, using its cash to buy shares. The idea is simple: since a company can’t own itself, the buyback reduces the number of outstanding shares on the market.
Buybacks can be carried out in two ways:
1)Shareholders may be presented with 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 and at usually a price higher than the current market level.
2) Companies can buy shares on the open market over a long-term period.
In many ways a buyback is similar to a dividend because the company is distributing money to shareholders. An advantage buybacks have over dividends is that they are taxed at a lower capital-gain tax rate whereas a dividend is taxed at ordinary income tax rates.
One catch with buyback programs is that sometimes they are little more than a marketing move. The media will report that a company has announced a buyback program, but this does not mean firms are obligated to buy back shares. Announcements are often worded as, “a buyback up to $X dollars” or “up to X million shares over the next X number of years”. While this usually means the board has approved an amount to be bought back, there is no contractual or legal obligation to carry this pledge through.
What Buybacks Mean
For the most part an announcement for a share buyback is considered good news for shareholders; however, there are many different reasons a company might want to repurchase shares, so don’t automatically consider all buybacks to be positive.
If you ask management of a company they will likely tell you a buyback is logically the use of a company’s resources. After all, the goal of a firm’s management is to maximize return for shareholders, and a buyback may in fact increase shareholder value. The prototypical line in a buyback press release is “we don’t see any better investment than in ourselves”.
When the market is bad, this reasoning can often be justified because stock prices are depressed and earnings multiples tend to be lower. If you think about it, management should know better than anyone when their company is undervalued. 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 copious amounts of cash on hand because cash typically earns less than 2-3% interest.
The second reason a company might do a buyback is to prop up its share price and other financial ratios. This approach is more questionable if reducing the number of shares is not for creating more value but just for making financial ratios look better. Plowing extra cash back into stock reduces outstanding shares and also reduces the assets on the balance sheet (because cash is an asset). Thus, return on assets (ROA) actually increases because assets are reduced, and return on equity (ROE) increases because there is less outstanding equity.
To use another example, suppose a company earnings is identical before and after a share repurchase. Figures such as earnings per share (EPS) and the P/E ratio would look better even though earnings did not improve. Because analysts and investors carefully scrutinize many of these figures, an improvement in them could jump-start the stock. This strategy, however, isn’t very effective in the long term unless the stock is truly the best possible investment.
Another reason for a buyback is to reduce dilution caused by employee stock option plans. Companies that gave a free lunch by issuing massive stock options to employees during the big bull market of the late 90s have paid the price because every option that is exercised increases outstanding shares and reduces EPS. Many companies (especially the techs) feel they have to start repurchasing shares to avoid excessive dilution, which would drive down share price even further.
In the last instance, buying back stock is not for the purpose of retiring the shares and reducing the number of outstanding shares. Here, the company holds the shares are to defend against takeover bids or used for buying other companies.
Conclusion
There are some excellent arguments for and against share buybacks, so what is the answer? As so often is the case in financial matters, the answer depends on many things. If a stock is undervalued and buybacks truly represent the best investment for a company, the buyback is positive. Watch out, however, if a company is merely using buybacks to prop up its ratios or get out from under excessive stock option grants.
