Ask most investors about how buying a stock can help them build wealth, and the answer you will get is by two ways, stock price appreciation and dividends. However many overlook the third way, stock buyback. Let us find out more about this third way.
The Meaning of Buybacks
A stock buyback is nothing but a company buying back its shares from the marketplace. Buyback can be thought as a company investing in itself. With the extra cash in hand, the company can use it to buy its own shares. These shares are absorbed by the company leading to reduced number of outstanding shares in the market. When this happens, the ownership of each investor increases because there are fewer shares in all. Company buybacks are usually perceived by the market as a positive thing which often causes the share price to shoot up.
Typically, buybacks are carried out in one of two ways:
Tender Offer: Shareholders may be presented with a tender offer by the company to tender a portion or all of their shares within a certain time frame. The tender offer has the number of shares the company is looking to repurchase and the price they are willing to pay for them. The price is almost always at a higher price than the market price. When investors take up the offer, they will state the number of shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.
Open Market: The second alternative a company has is to buy shares on the open market, just like an individual investor would, at the market price.
So why does a company decide to buyback ? Lets find the motive.
Reasons For Buyback
Build Investor Faith: When a company announces a buyback it is usually perceived by the market as a positive thing, which often causes the share price to shoot up. This in turn is good for the investors and eventually what the company’s management wants for their investors.
Discount Recovery: When the company feels the market has discounted its share price too steeply, they try to revive it by buyback. By buying back its own shares, the company sends out a positive sign to the market that the stock price has gone too far in discount.
Improve Financial Ratios: A company might pursue a buyback solely to improve its financial ratios which the investors and traders heavily focus upon. This definitely is a questionable motive. If reducing the number of shares is not done in an attempt to create more value for shareholders but rather make financial ratios look better, there is likely to be a problem with the company’s management.
Reduce Dilution: A company might pursue a buyback to reduce the dilution that is often caused by generous employee stock option plans. Stock options have the opposite effect of buyback, as they increase the number of outstanding shares when the options are exercised, which affects financial ratios such as EPS, P/E and ROA.
Effects of Buyback to Financial Ratios
With company buyback, the financial ratios start looking good. To begin with, buyback reduces the assets (cash) of the company on the balance sheet since that cash is used to buyback the company stocks. As a result, return on assets
(ROA) actually increases. ROA gives an idea as to how efficient a company is at using its assets to generate earnings. ROA is calculated by dividing a company’s annual earnings by its total assets. Also return on equity
(ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positive signs, thus attracting more investors.
Example on Buyback
Let us take an example of a company Money Inc, that has $50 million in total assets and net income of $2 million. Their stock price is $15/share and they have $20 million in cash. Also assume there are a total of 10 million outstanding shares. Now Money Inc. decides to buyback 1 million shares. This means they will be spending $15 million cash and reducing the outstanding shares to 9 millon. Lets see how this buyback changes the ROA and ROE.
The cash holding of Money Inc. dropped from $20 million to $5 million. The total asset dropped from $50 million to $35 million, since cash is an asset. This leads to an increase in its ROA, even though there is no change to the earnings.
Before buyback ROA = $2m/$50m = 4.00%
After buyback ROA = $2m/$35 m = 5.71% (the market often likes higher ROA)
Before buyback EPS = $2m/10 m shares = $0.20
After buyback EPS = $2m/9 m shares = $0.22 (the market often likes higher EPS)
Before buyback P/E = $15 share price/$0.20 EPS = 75
After buyback EPS = $15 share price/$0.22 EPS = 68 (the market often likes lower P/E ratio)
Based on the P/E ratio as a measure of value, the company is now less expensive than it was prior to the repurchase despite the fact there was no change in earnings.
Conclusion: Company buybacks can be good or bad. As is so often the case in finance, there is no definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up financial ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution.
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