When a company announces a stock buyback or repurchase, it’s time to take a close look at what’s behind the action.
This financial maneuver can be good news for shareholders or a smokescreen to cover pitiful financial ratios.
First, let’s define stock buybacks, also called repurchases, and see how they work.
The company wants to purchase outstanding shares of its stock, that is shares held by the public outside of its control. It can do this one of two ways:
It can tender an offer to existing stockholders to buy up to a certain number of shares at a fixed price (usually at a premium over the current market price). There is a time limit on the offer.
The other way is to buy the shares in the open market over a period. Companies often use this method when the stock’s price is especially depressed.
That’s the two main ways it is done, but why would a company want to buy back its own shares?
The Why of Stock Buybacks
There are several reasons a company may want to buy back shares of its own stock, some of them for the benefit of stockholder, while others have less altruistic purposes.
Here are some of the reasons, both good and bad that a company might do a stock buyback:
If a company is sitting on a large sum of cash and must decide how to invest it, one of the options is to distribute part of it to shareholders.
Companies can do this either of two ways: as dividends or buy buying up outstanding shares. If the company chooses to buy up shares, stockholders benefit even if they don’t sell by the reduction in outstanding shares.
If a company’s stock is suffering from low financial ratios, buying back stock can give some of the ratios a temporary boost.
Key ratios like earnings per share (EPS) and price earnings ratio (PE) look better because they are based on the number of outstanding shares. Reduce the number of shares and even though earnings don’t change, the EPS looks better.
Another reason companies buy back stock is to cover large employee stock option programs. The effect of these programs, which were out of control during the tech boom of the late 1990s, was to dilute the stock and shareholder’s equity. Buying back shares reduces dilution and increases shareholder value.
Some companies buy back shares as protection against unfriendly takeovers from other companies. By gathering outstanding shares off the open market, the company makes it more difficult for a raider to take control.
Conclusion
Stock buybacks can be great for stockholders if done because that is the best use of cash and the price is right. However, watch out of financial slight of hand that seeks to cover up weak ratios or poorly managed employee stock option plans.
