Education: Aggressive Growth Investing

Printable Version

Companies "Buyback" Their Own Stock

Corporate America’s balance sheets are overflowing with cash these days, and there is a lot of buzz in the media as to what should be done with it. Clearly, there are worse problems to have, but nonetheless, this issue has caused some shareholders and analysts to ask questions. Many companies are choosing to buy back their own shares in what is known creatively enough as a “stock buyback”. This can be a good idea, but some question whether buybacks are the best use of a company’s excess cash. Be suspicious of young, aggressive growth companies that announce big stock buybacks.

What is a Buyback?

A company engages in a stock buyback by buying its own shares from the marketplace. Why would any company do that? Quite simply, buying back shares reduces the outstanding supply of shares, which increases earnings per share. The same amount of profit is spread out among fewer shares, which means each shareholder owns a larger portion of the company.

The buybacks usually occur through open market purchases, which means companies buy their stock just like you or I would through the stock market. Once the shares are purchased, they are usually cancelled or kept as “treasury stock”. These shares do not have voting rights, but can eventually be re-issued if the company wishes.

Are Buybacks Good?

For the most part, buybacks are a positive for stockholders, but as with most financial issues, there is another side to the story. Companies that announce large buybacks often see their stock jump on the news, as the market perceives a shareholder-friendly management trying to enhance value.

In many cases, buying back stock is the best use of extra cash. Press releases often state that buying back their stock is the best way to reward shareholders. This is true if the stock is undervalued or at least perceived to be undervalued.

IBM announced a huge buyback during the Asian financial crisis in October 1997, which helped stabilize the market after a 7% plunge in the Dow Jones Industrials. This was after the stock was down huge, so it was probably a good idea to use excess cash to repurchase shares.

But………..

On the other hand, companies sometimes announce buybacks in order to hide other issues. Many technology and growth companies issue huge amounts of stock and options to lure the best talent. This severely dilutes the existing shareholders, and stock buybacks are a way to counter this. The problem is that this precious cash could be better used by being re-invested into the business rather than buying back shares for purely cosmetic reasons.

Also, some companies announce buybacks to get a short-term boost in their stock, but never actually go through with the purchase. The market rewards the company in anticipation of the shares being bought back, but there is no obligation for the company to actually do it. Of course, investors will catch on over time if this becomes a common practice.

Aggressive growth companies that announce buybacks definitely deserve extra scrutiny from investors because financing future growth should be their top priority. Most investors in aggressive growth stocks don’t buy these companies for buybacks and dividends; they buy them for huge capital gains potential. Young companies usually cannot afford to put too much money into buybacks. This is not to say it never should be done, but it definitely warrants investigation if it happens often.

The bottom line is to do a little more digging after a company announces a stock buyback. Ask yourself if the buyback is warranted or if there are better uses for a company’s war chest. A little more homework should not be a problem for the wise investor. Figuring out the company’s motives is well worth the extra effort.