Education: Value Investing

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Companies "Buyback" Their Own Stock

When a company announces a stock buyback, also commonly referred to as a share repurchase, is this a good thing or a bad thing for investors?

Such action can be an indication that management believes the stock price is undervalued. On the other hand, the company may be compelled to buy back its own shares for other reasons—reasons that are not entirely in the best interests of its stockholders.

Stock Buybacks Defined

When a company elects to purchase outstanding shares of its own stock—shares held by the investing public—it can accomplish this through one of two ways:

1. The company can tender an offer to existing stockholders. A tender offer invites shareholders to sell their stock, generally at a price above the market price, within a certain period of time.

2. The company can purchase shares of its stock in the open market, similar to the way individuals would. In this case, the company would simply pay market price.

Whichever method the company chooses, it has decided to invest in itself for one reason or another. But is this the best use of its cash? Wouldn’t it be better if the company reinvested excess cash for future growth? Or perhaps it should distribute the cash to shareholders in the form of a dividend.

What gives? Why are companies going down this road?

Good, Bad or Just Plain Ugly?

“We don't see any better investment than in ourselves.”

These are words that have been uttered by numerous companies after they announced a share buyback. The company is saying that its shares are currently selling at a discount to their fair value. They are a good bargain at this price. However, as we alluded to earlier, a company can have a number of other motives behind a share repurchase. Here are some other potential reasons, both good and bad.

1.) A company finds itself with a large amount of excess cash on its hands and must decide what to do with it. A number of companies will give its shareholders a piece of the pie. Some choose to issue dividends while others prefer to buy back their own shares (some do both). Less shares outstanding give investors a greater ownership position in the company.

2.) A company may simply be trying to make its financial ratios look prettier, when in reality, it is not a fundamentally sound organization. When a company buys back its shares, this can give their ratios a temporary boost.

a. Since share repurchase programs reduce the number of shares outstanding, ratios tied to this measure, such as earnings per share (EPS) and price-to-earnings ratio (P/E ratio), can be given a nice facelift.

b. When a company spends its cash, its assets are reduced. This will cause its return on assets (ROA) to increase. Also, return on equity (ROE) is upped because there is less outstanding equity.

3.) Another motive behind a buyback may have to do with large employee stock option programs. When employees exercise their stock options, the number of shares outstanding actually increases. This can lead to dilution—a reduction in each current shareholder's fractional ownership. Share repurchases help to rectify this situation.

4.) Companies may find themselves in a position where another company is planning an unfriendly or hostile takeover—a takeover which goes against the wishes of the target company's management and board of directors. If a company can succeed in buying back a substantial amount of its own shares, this makes it more difficult to be taken over.

Repurchase of Stocks with Healthy Zacks Ranks

Investors obviously would like companies to buy back shares of their own stock because they are currently undervalued (or for any reason that is in their best interest). The market has yet to realize the company’s true value, and once it does, they would enjoy the price appreciation that should result. If management is looking to give their suffering ratios an extreme makeover, this can spell bad news for investors.

When trying to determine the motives behind a company’s share buyback program, take a quick look at its current Zacks Rank. If a company is receiving positive earnings estimate revisions, leading to an attractive Zacks Rank, and decides to repurchase its shares, this can be a recipe for success (Learn more about the Zacks Rank). A fundamentally sound company investing in itself—I like the odds of this one, don’t you?