Stock Investing 101 – Stock Repurchase

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Stock Repurchase

Companies sometimes buy back their shares from the open market as a way to increase shareholder value. Distributing dividends is another way of giving value back to the shareholders.

When the board of directors decides to initiate a stock repurchase program, it authorizes a maximum dollar amount of shares or maximum number of shares to be bought back. The target price per share will not be disclosed but it should be close to the recent trading price.

However, just because a stock repurchase plan is announced does not mean that it will be carried out. If the price is not right, like any other investor, the company will not proceed with the buy back.

How does shareholder value increase?

Firstly, the act of reducing the number of available shares in the market should cause the stock price to rise as basic law of supply and demand would suggest.

The more impactful effect of share buy-backs on stock price is the result of the indirect boost to the earnings per share number – an important metric for stock valuation. The following example illustrates this process.

An Example

During the past year, XYZ company booked $10m in profits in which $1m is from interest earned off a $40m cash hoard. The company has 10 million shares outstanding, giving it an EPS of $1 and with a current market price of $20, the stock has a P/E ratio of 20.

The company then announced that it would buy back $40m worth of its own shares Let us assume it is able to buy them at the current market price of $20 and with $40m, the company proceeds to retire 2 million shares.

Assuming no growth in earnings, the company will earn $9m (less the $1m interest income) the following year. With only 8 million shares outstanding, EPS will have grown to $1.13. If the P/E ratio remains at 20, then the stock price should appreciate to $22.60.

Which companies are likely to buy back shares?

Stock repurchase programs are likely to be announced by mature companies whose management feels that the stock is currently underpriced.

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Mature companies possess the capability to generate, or have already generated, large cash surplus. Younger companies typically need to reinvest any excess cash to expand the business.

So instead of distributing dividends, management may decide that buybacks are a superior way to distribute value back to the shareholders.

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Investing 101: Common Stock and Preferred Stock

Stock is stock, right? Not really. The two broad classifications — common stock and preferred stock — have important differences.

A preferred stockholder has a priority of claims against corporate assets in the event the company declares bankruptcy and reorganizes. As assets are liquidated, payments go first to creditors and bondholders; then preferred stockholders are paid and, last of all, common stockholders.

Dividends to preferred stockholders are different as well, often a contractual obligation. Common stock dividends are determined by the board of directors each year. These differences make preferred stock a sort of hybrid between a bond and a stock.

The common stockholder, on the other hand, is more likely to make profits from stock price appreciation than with preferred stock. Common stock moves as market conditions change, making common stock investing the default choice for many.

Common stock also pays dividends as declared each year, with quarterly ex-dividend date (the date when stockholders of record earn a dividend) and payment date (about one month later).

A second benefit is that as a common stockholder, an investor has the right to vote for members of the board, with each share representing one vote in most cases.

So while preferred stock is safer, it is not as likely to move in value based on market forces of supply and demand; common stock is not as safe, but it is potentially more profitable.

The comparison gets more complex when you consider the many different classifications of common stock:

Participating preferred entitles stockholders to increases in dividends when common stock dividends move higher.

Adjustable-rate preferred pays a variable dividend based on Treasury bill rates or rates of other securities.

Convertible preferred is stock that comes with a known conversion price. If that price is reached, the preferred can be traded for common stock.

And callable preferred stock (also called “redeemable”) comes with the provision that the issuer can repurchase shares at a specified price.

Which kind of stock should you buy?

It’s a matter of how much risk you can afford to take, versus how much profit potential you seek.

A very conservative investor will be drawn to the seniority of preferred stock over common stock, while recognizing that this safety comes with much lower profit potential. Essentially, preferred stockholders accept the guaranteed but relatively low-yield dividend.

A moderate investor will find common stock more appealing because of its potential for growth in value, and should be willing to live with market risk. The risks of common stock are mitigated by paying attention to the capital strength of the issuing company. Thus, common stock in a large cap company is going to be safer than that of a small cap company. However, the profit potential (and market risk) of the smaller company is going to be greater.

Picking the right company and the right kind of stock is determined by risk tolerance as well as your knowledge and experience. It is always a balancing act between two opposing forces: profit/loss potential, versus safety.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2020). He lives in Nashville, Tennessee and writes full time.

Stock Buybacks: A Breakdown

There are several ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways, there are other ways for companies to share their wealth with investors. In this article, we will look at one of those overlooked methods: share buybacks or repurchases. We’ll go through the mechanics of a share buyback and what it means for investors.

Key Takeaways

  • A stock buyback occurs when a company buys back its shares from the marketplace.
  • The effect of a buyback is to reduce the number of outstanding shares on the market, which increases the ownership stake of the stakeholders.
  • A company might buyback shares because it believes the market has discounted its shares too steeply, to invest in itself, or to improve its financial ratios.

What Is a Stock Buyback?

A stock buyback, also known as a share repurchase, occurs when a company buys back its shares from the marketplace with its accumulated cash. A stock buyback is a way for a company to re-invest in itself. The repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. Because there are fewer shares on the market, the relative ownership stake of each investor increases.

How Does a “Buyback” Work?

There are two ways that companies conduct a buyback: a tender offer or through the open market.

1. Tender Offer

The company shareholders receive a tender offer that requests them to submit, or tender, a portion or all of their shares within a certain time frame. The offer will state the number of shares the company wants to repurchase and a price range for the shares.   Investors who accept the offer will state how many 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.

The market typically perceives a buyback as a positive indicator for a company, and the share price often shoots up following a buyback.

2. Open Market

A company can also buy its shares on the open market at the market price. It is often the case, however, that the announcement of a buyback causes the share price to shoot up because the market perceives it as a positive signal.

The Motives

Why do companies buy back shares? A firm’s management is likely to say that a buyback is the best use of capital at that particular time. After all, the goal of a firm’s management is to maximize return for shareholders, and a buyback typically increases shareholder value. The prototypical line in a buyback press release is “we don’t see any better investment than in ourselves.” Although this can sometimes be the case, this statement is not always true.

There are other sound motives that drive companies to repurchase shares. For example, management may feel the market has discounted its share price too steeply.   A stock price can be pummeled by the market for many reasons such as weaker-than-expected earnings results, an accounting scandal, or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it can be a sign that management believes that the market has gone too far in discounting the shares—a positive sign.

Improving Financial Ratios

Another reason a company might pursue a buyback is solely to improve its financial ratios—the metrics used by investors to analyze a company’s value. This motivation is questionable. If reducing the number of shares is a strategy to make the financial ratios look better and not to create more value for shareholders, there could be a problem with management. However, if a company’s motive for initiating a buyback is sound, better financial ratios as a result could simply be a byproduct of a good corporate decision. Let’s look at how this happens.

First, share buybacks reduce the number of shares outstanding. Once a company purchases its shares, it often cancels them or keeps them as treasury shares and reduces the number of shares outstanding in the process.

Moreover, buybacks reduce the assets on the balance sheet, in this case, cash. As a result, return on assets (ROA) increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity.   In general, the market views higher ROA and ROE as positives.

Suppose a company repurchases one million shares at $15 per share for a total cash outlay of $15 million. Below are the components of the ROA and earnings per share (EPS) calculations and how they change as a result of the buyback.

Before Buyback After Buyback
Cash $20,000,000 $5,000,000
Assets $50,000,000 $35,000,000
Earnings $2,000,000 $2,000,000
Shares Outstanding $10,000,000 $9,000,000
ROA 4.00% 5.71%
Earnings Per Share $0.20 $0.22

As you can see, the company’s cash hoard has been reduced from $20 million to $5 million. Because cash is an asset, this will lower the total assets of the company from $50 million to $35 million. This increases ROA, even though earnings have not changed. Prior to the buyback, the company’s ROA was 4% ($2 million/$50 million). After the repurchase, ROA increases to 5.71% ($2 million/$35 million). A similar effect can be seen for EPS, which increases from 20 cents ($2 million/10 million shares) to 22 cents ($2 million/9 million shares).

The buyback also improves the company’s price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, the market often thinks a lower P/E ratio is better. Therefore, if we assume that the shares remain at $15, the P/E ratio before the buyback is 75 ($15/20 cents). After the buyback, the P/E decreases to 68 ($15/22 cents) due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS, which leads to a better P/E.

Based on the P/E ratio as a measure of value, the company is now less expensive per dollar of earnings than it was prior to the repurchase despite the fact there was no change in earnings.

A buyback will always increase the stock’s value and benefit the shareholders in the short term.

Dilution

Another reason that a company may move forward with a buyback is to reduce the dilution that is often caused by generous employee stock option plans (ESOP). 

Bull markets and strong economies often create a very competitive labor market. Companies have to compete to retain personnel, and ESOPs comprise many compensation packages. Stock options have the opposite effect of share repurchases as they increase the number of shares outstanding when the options are exercised. As in the above example, a change in the number of outstanding shares can affect key financial measures such as EPS and P/E. In the case of dilution, a change in the number of outstanding shares has the opposite effect of repurchase: it weakens the financial appearance of the company.

If we assume that the shares in the company had increased by one million, the EPS would have fallen to 18 cents per share from 20 cents per share. After years of lucrative stock option programs, a company may decide to repurchase shares to avoid or eliminate excessive dilution.

Tax Benefit

In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders albeit in an alternative way. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate. Dividends, on the other hand, are taxed at ordinary income tax rates when received. Tax rates and their effects typically change annually; thus, investors consider the annual tax rate on capital gains versus dividends as ordinary income when looking at the benefits.

The Bottom Line

Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. Buybacks reduce the number of shares outstanding and a company’s total assets, which can affect the company and its investors in many different ways. When looking at key ratios such as earnings per share and P/E, a share decrease boosts EPS and lowers the P/E for more attractive value. Ratios, such as ROA and ROE, improve because the denominator decreases creating increased return.

In the public market, a buyback will always increase the stock’s value to the benefit of shareholders. However, investors should ask whether a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price, or to get out from under excessive dilution.

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