Saturday, 14 January 2012

Stock Buybacks

What is a stock buyback?
A stock buyback occurs when a company repurchases outstanding shares from the marketplace, reducing the total number of shares that it has out. It helps indicate that a company thinks that its shares are undervalued, and the removal of shares from the marketplace increases the value of the remaining shares.

Why is this important?
The share repurchase increases the Earnings per Share (EPS) because the number of shares has been reduced. In addition, one important thing to note is that companies have a pool of savings that they utilize. They can choose to invest in research and development, build a new factory, etc. Since they choose to reinvest in their company by buying back shares, they show confidence that their company will do well, which is definitely a good sign for investors.

Let's say that company A did not grow this year, but the management still wants to provide value to shareholders. They have one million outstanding shares at a price of $100 a share, so their market capitalization is $100 million. In addition, this year they made a profit of $10 million, which is the same as last year, so there is no profit growth. If a stock buyback is approved, they could use the $10 million to buy back shares in their own company and take them off the market, so that the number of oustanding shares are reduced. The $10 million dollars can buy 100,000 shares, so now there are 900,000 outstanding shares worth $100 million. Under this simple analysis, that means that each share is now worth $111. If you were a lucky shareholder in this company, you would have made $11 even though the company did not grow at all from last year!

When does it Occur?
Since buybacks are generally a good thing, it would be nice to know which companies are starting to buy back stock soon so that you could purchase a stock position in the company. Although they are relatively unpredictable, when a company's stockpile of savings keeps on increasing even after paying their R&D and operating costs, it is more likely they will buy back stock. For example, in the following picture from the Seattle Post-Intelligencer in 2004, you can see that Microsoft's cash reserves were rapidly increasing, and soon after they instituted a stock buyback and a special dividend for shareholders.

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