Are Stock Buybacks a Good Deal?
When a company announces a stock buyback or repurchase, its time to
take a close look at whats behind the action.
This financial maneuver can be good news for shareholders or a
smokescreen to cover pitiful financial ratios.
First, lets define stock buybacks, also called repurchases, and see
how they work.
The company wants to purchase outstanding shares of its stock, that is
shares held by the public outside of its control. It can do this one
of two ways:
It can tender an offer to existing stockholders to buy up to a certain
number of shares at a fixed price (usually at a premium over the
current market price). There is a time limit on the offer.
The other way is to buy the shares in the open market over a period.
Companies often use this method when the stocks price is especially
depressed.
Thats the two main ways it is done, but why would a company want to
buy back its own shares?
The Why of Stock Buybacks
There are several reasons a company may want to buy back shares of its
own stock, some of them for the benefit of stockholder, while others
have less altruistic purposes.
Here are some of the reasons, both good and bad that a company might
do a stock buyback:
If a company is sitting on a large sum of cash and must decide how to
invest it, one of the options is to distribute part of it to
shareholders.Companies can do this either of two ways: as dividends or
buy buying up outstanding shares. If the company chooses to buy up
shares, stockholders benefit even if they dont sell by the reduction
in outstanding shares.
If a companys stock is suffering from low financial ratios, buying
back stock can give some of the ratios a temporary boost.Key ratios
like earnings per share (EPS) and price earnings ratio (PE) look
better because they are based on the number of outstanding shares.
Reduce the number of shares and even though earnings dont change, the
EPS looks better.
Another reason companies buy back stock is to cover large employee
stock option programs. The effect of these programs, which were out of
control during the tech boom of the late 1990s, was to dilute the
stock and shareholders equity. Buying back shares reduces dilution and
increases shareholder value.
Some companies buy back shares as protection against unfriendly
takeovers from other companies. By gathering outstanding shares off
the open market, the company makes it more difficult for a raider to
take control.
Conclusion
Stock buybacks can be great for stockholders if done because that is
the best use of cash and the price is right. However, watch out of
financial slight of hand that seeks to cover up weak ratios or poorly
managed employee stock option plans.
