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Company Stock Buybacks

Typically, investors calculate their return from a stock as capital appreciation plus dividend payments. For non-dividend paying companies, the growth prospects of the company decide the stock price and thereby, the return for the shareholder. However, a corporation can also provide value to a shareholder through a share buyback program. This post will look at some details of the program and how it adds value for the shareholder.

What is a Share Buyback Program?

A company with a share buyback program essentially buys its own shares from the market. This buyback reduces the number of outstanding shares and increases the value of the existing shares. The repurchased shares may be retired or kept as treasury shares.

Consider a simple example where FGH Corporation has 1,000,000 outstanding shares selling at $50 each. The company has a lot of cash on hand and decides to buyback 200,000 shares. After absorbing the 200,000 shares, the number of outstanding shares are reduced to 800,000. If the company earns a net income of $4,000,000 in the next year, then the Earnings per Share (EPS) will be $5.0 instead of the $4.0 (i.e., 4,000,000/1,000,000) it would have been without the share buyback. So, as you would realize, FGH Corporation has managed to increase shareholder value by buying its shares back.

How do Companies Buy Shares Back?

From shareholders. A company can offer to buy shares from individual shareholders by providing written notice of their interest in the number of shares, and a price range for the shares. Generally, the price offered will be higher than the market price but the offer will be set to expire after a predetermined time period.

From the market. The other option for a company is to purchase its own shares from the market just like any other investor. The company would pay the existing market price for a share, but it is likely that the price will increase once the intent to buy shares back is revealed.

Perception of the Share Buyback Program

According to company management, buying back its shares is a way to return wealth to its shareholders. Nevertheless, it can also be construed to mean that the management does not know of any better use for its cash at that point of time and hence, it deems share buyback as the best way forward. As much as a shareholder can rejoice in the increased value of their shares, it also raises the question of how the company will grow if it has exhausted its growth prospects and reached a saturation point.

A good management team will initiate a share buyback program when its stock price is cheap. This ensures that the company spends the least amount of cash possible, while accomplishing its objective to maximize shareholder value.

In addition, buying shares back when they are cheap provides the company with the opportunity to reissue them at another time without causing any dilution. Share buybacks indicate to the market that the company management considers the stock to be undervalued to such a level that it is taking advantage of the deal. They also improve the financial ratios such as Return on Assets by reducing assets (cash), lowering the P/E ratio, and increasing equity. Share buybacks are the antithesis to exercised stock options, which dilute the number of outstanding shares.

Have you held a stock that bought its shares back? Would you consider buying a stock that did not pay a dividend but has bought its shares back in the past (for the right reasons)?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 11 comments… add one }
  • Paul T November 30, 2011, 9:32 am

    What happens when a company buys back stock, not to retire it, but to use for stock options for it’s employees? These shares aren’t really retired, but still exist, but now owned by the corporation.

    How are these buybacks differentiated in the market and are they easily identifiable?

  • Steve November 30, 2011, 10:54 am

    I’ve worked for two companies that have issued “Normal Course Issuer Bids” for up to 5% of outstanding shares, usually valid for a 1 year period.

    In other words, a buyback when the stock has been low for a long period. In both cases, the company never actually bought any significant number of shares (much less than 1% of outstanding).

    I should also mention both were TSX listed, but very thinly traded small and mid cap.

    Furthermore the stock price did not move back up over the year. In both cases I think the companies had no intention of using their cash for buyback, they were simply hoping to “talk the stock up”, on both cases it did not work.

  • Paul T November 30, 2011, 1:02 pm

    @Steve. That is one reason I’d like to see a “special dividend” or increased payout of the existing DIV rather than a stock buyback announcement.

    With the money in my hands, I can buy more shares or diversify my portfolio back to my target allocations.

  • Steve @ Grocery Alerts November 30, 2011, 2:02 pm

    Is there any special formula analysts use when looking at companies that frequently buy back shares?

    When making a rating on a company and they haven’t bought back shares is this considered bad news?

    Clark brings up a great point about buying back shares only at certain price levels.

  • joncosmo November 30, 2011, 3:33 pm

    @Paul T. Totally agree. I would much rather have the money in my hands in the form of a special dividend or an increased dividend.

  • Clark November 30, 2011, 7:17 pm

    I can relate to your views about preferring special or increased dividends. The phrase “A bird in the hand is better than two in the bush” springs to mind.

  • Cherleen @ My Personal Finance Journey November 30, 2011, 9:09 pm

    If I have some stocks that does not earn, I would, of course, sell them. Either offer a buyback to the company or to other interested investors.

  • Al December 1, 2011, 12:04 pm

    Paul T & joncosmo & Clark,

    Why not sell a proportionate amount of your shares to get money in your hands (if the company buys back 5%, you can sell 5% of your shares) – your ownership % in the company will stay the same. Granted you have to pay a broker comissions, but if there is a capital gain it would be taxed more favorably than dividends?

  • Paul T December 1, 2011, 12:17 pm

    @Al, because as @Steve Mentioned, the announcement does not always translate into an actual buyback. So I’d have to watch the company news daily to see if the stocks are bought back during the announced window and sell accordingly.

    My thing isn’t that I want a dividend per say, just that the announcement of a buyback doesn’t mean much if the company never executes. Again, as @Steve said, it might be more of a marketing ploy to support / raise the stock price rather than deliver real value to long term holders.

    Of course a higher price is value to shareholders, but it isn’t sustainable if there isn’t a true increase in value of the company. Eventually it’ll trend back down to the pre-announcement levels.

  • Jeremy December 3, 2011, 5:38 pm

    I am not a huge fan of buybacks as it indicates that the company has nothing better to do with its cash. However, if it is the only option then it can make sense over time. The trouble is is that it often takes awhile before investors see the impacts of the buyback.

    I would much prefer my companies to take their cash and invest it in growth or cost savings initiatives. For example, expand to another global market or invest in a better and more efficient manufacturing line. These actions can bring better longer term growth for the company as it improves earnings.

  • derek December 11, 2011, 11:53 am

    Would a RIM buyback be smart now if they had extra cash on hand as the stock price seems really low.

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