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Stock Buybacks: THE SKINNY
Sectors: Fundamental
Corporate
Americas 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, it is a good problem to have, but nonetheless, it 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 companys excess cash. 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
shares. 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 shareholders, but as with most financial issues,
there is another side to the story. Companies that announce large
buybacks often see their shares rally 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 (NASDAQ: 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. 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 companys war chest. Figuring out the companys motives
could be good for your wallet. |
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