A stock buyback, also known as a share repurchase, happens when a company repurchases shares of their own stock, either through a tender offer or in the open market, with their cash reserves. Stock shares are absorbed by the company, reducing the number of outstanding shares. This results in each stockholder’s percentage of ownership of the company rising, because there are fewer shares. In theory, the company’s stock price should rise.
Why Repurchase?
Corporate management often cites that a share repurchase is the best use of capital at that point in time. What better investment is there than in themselves, right? Since the goal of management is to maximize the return for shareholders, and a buyback often increases shareholder value, a buyback makes sense. However, this can also send the message that the company has no prospects for future acquisitions.
Ahh, but wait! Couldn’t the company increase dividends? They could. However, as custom in the American markets, once a company increases dividends, they generally do not lower them at a later date. Analysts negatively view companies that cut dividends once they have been established. Repurchasing shares allows a company to keep dividend amounts steady. Raising dividends to levels that might not be sustainable is not wise. We prefer a company to provide consistent dividends throughout the years, perhaps making an extra dividend payment if management is truly looking to benefit the shareholders.
Sometimes management may feel that the stock price is undervalued, if the stock is currently trading below what they feel is the intrinsic value of the stock. In this case, management may repurchase shares in hopes of increasing the stock price. Once the market corrects the undervaluation, the company may reissue the stock shares for a profit.
A buyback can also make financial ratios appear better. After shares are repurchased, there are fewer shares outstanding. When the same amount of earnings are spread over fewer shares, earnings per share (EPS) increases. Assuming the share price remained the same before and after the buyback and EPS increased, the stock should have a lower price-to-earnings ratio (P/E). Since cash assets, were used to purchase shares, there should be less assets to divide by earnings, thus increasing return on assets (ROA).
The repurchase of the shares is also a way to fight share dilution. If a company offered stock option plans to attract employees, over time, shares that were issued at a discount wind up on the market. This practice is considered dilutive to other shareholders as it causes reduced per share fundamentals, i.e., lower earnings per share. When a company buys back shares, it helps get these shares off the market.
The Problems with Buybacks
Companies often are under a lot of pressure from investors to return cash to the shareholders, either by way of a buyback or increased dividends. Yet management may have plans in the future for the cash in terms of internal research and development projects or even acquisitions. Investors feel that managers have more information to make their decision to repurchase shares.
Sometimes repurchases are initiated to boost stock ratios or provide a quick fix to an ailing stock price. if the company repurchases shares to meet expectations, it can be a slippery slope when continued for long periods of time. Little value is offered to the company or investors.
Stock buybacks can be both good and bad for a company. It often depends on the reasons behind the buyback and the sentiment in the market. It never makes sense to buy back shares at a price higher than the intrinsic stock value.
At Henssler Financial we believe you should Live Ready. If you have questions regarding your stock holdings or tendered repurchase offers the experts at Henssler Financial will be glad to help. You may call our experts at 770-429-9166 or e-mail at experts@henssler.com.
Disclsoures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
