Thursday, January 7th, 2010
How Buybacks Impact Stocks and Valuation
Stock buybacks are often utilized by public companies to use up spare cash, boost earnings, and demonstrate confidence to shareholders and potential investors. The theory is that if a company’s earnings per share are increased, then the stock price will increase assuming a constant price-earnings multiple.
In addition to the positive elements, stock buybacks can also contain many drawbacks. Some companies may use buybacks in order to cover up financial mismanagement, such as large employee stock option programs where by a buyback is announced to simply repurchase their shares and not directly benefit stockholders.
Types of Stock Buybacks
There are two basic types of share buybacks:
- Companies can announce a tender offer to existing shareholders to acquire a certain number of shares at a fixed price. Typically, this price is at a premium to the market price and a time limit is set on the offer.
- Companies can purchase stock on the open market over a set or indefinite period of time. Often times, companies do this when they believe that their stock prices are depressed and want to capitalize on the opportunity.
As an alternative to buybacks, companies can issue dividends to shareholders. Dividends are beneficial due to the prevalence of a certain type of stock valuation that uses dividends, and the fact that many investors prefer to purchase stocks that pay dividends. However, dividends do not increase EPS like buybacks.
Reasons for a Stock Buyback Program
Companies may institute stock buyback programs for a number of reasons, including:
- Excessive Cash – A company may have too much cash on its books and, if their share price is deemed depressed, may decide to use the cash to repurchase its own stock.
- Prevent Takeovers – Companies that carry a lot of cash on their books are more attractive takeover targets, while those with higher earnings ratios will command higher premiums for potential buyers.
- Improve Ratios – Companies can use stock buybacks to improve a variety of ratios, including EPS and profitability ratios, with the exception of book value ratios that can see a marginal drop.
The Takeaway…
- Stock buybacks can be used by companies for good reasons – like using up spare cash – or bad reasons – like covering up excessive stock option usage.
- Stock buybacks are generally positive for investors as they increase earnings per share – be reducing the number of shares outstanding – and thereby increase the stock price, assuming a constant price-earnings multiple.
Written by Simon Monger
