In times of rising market prices and rapid stock price growth, investors and options advisory services like ours are confronted with certain phrases and techniques that occur more frequently.
One of the techniques which has got a lot more attention lately from large US based companies is the stock buybacks. Investors must make rational decisions on whether they want to buy stock or stock options based on the information that companies release to the market.
Making these decisions is impossible without fully understanding the various ways companies can affect their share capital and use their funds, which is why understanding stock buybacks will be the focus of this article.
What is Buyback?
In the simplest possible terms, a stock buyback can also be called a share repurchase. Ordinarily, the shares in a NYSE or NASDAQ listed company pass from private buyers to private sellers. These buyers and sellers can be individual investors like you, who benefit from option advisory newsletters, or billion dollar hedge funds.
However, when a company undertakes a stock buyback, they assume the position of the buyer. They buy back their own shares from the stock market from those willing to sell.
The company uses it’s own cash reserves from it’s retained profits (the money which it does not pay out as dividends) to purchase these shares. Once the shares are purchased, they are “retired” or “absorbed” by the company. This means that they are no longer available for sale, as it is illegal for companies to hold their own shares. The effect is that the total number of shares on the stock market available for trading in that company decreases.
So why would a company conduct a stock buyback?
Why do Companies do it?
The main motivation for companies to begin a stock buyback from the open market is that it represents the best use of the cash of the company, or the capital. The goal of the managers of a company is to increase the value that accrues to the shareholders of that company.
The logic that underpins buybacks is that management has undertaken a decision making process about the best uses of their excess funds, and have identified purchasing shares in the company is the strongest investment that they can make.
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The alternatives to a stock buyback for excess cash can be paying out dividends to shareholders, acquiring a new company or investing in new staff, machinery or expansion into new markets.
Typically, a buyback will occur when management believes the share price of a company that is being traded on the market is too low. When the price is low, they can buy more of their own shares, and therefore receive a greater return on their investment. It is a vote of confidence in the company, as it shows that management believes that the value that the stock market is giving to their shares is lower than what they believe the value to be.
What Are The Advantages?
There are many advantages to share buybacks for a company, and this is the reason they are so closely watched by professional options advisory services, as they can provide a catalyst for share price movement.
The first advantage is that because share buybacks reduce the number of shares on the market, they can have the effect of improving financial metrics. For example, return on equity increases after buybacks, as there are fewer shares on issue, as well as less equity. So if the profits of a company stay the same, and the equity decreases, it logically follows that the total return on that equity will be greater in percentage terms.
In addition, buybacks require cash to purchase the shares on issue. The cash comes from the assets part of the company balance sheet, and buying shares reduces the amount of cash. If you reduce cash, another important metric, return on assets, will improve as long as profit stays the same, similar to what we saw with the return on equity example.
Also, as was mentioned earlier, a buyback signals the confidence of management in the future of the company, and shows that they believe the current market price represents a good investment. This kind of vote of confidence can translate to the rest of the market, who may also use the stock buyback as a signal to consider investing in the company, which will also drive share price gains as more people buy the remaining shares.
What Are the Disadvantages?
As with many things in options investing and options trading, there is another side to the stock buyback story. There are occasions when stock buybacks fail, or do not improve the total return of the shareholders.
The first is when the company buys the shares at the wrong price. If management is wrong, and the company shares are not undervalued, then they risk paying too high a price for their own shares. If this happens then the cash that the company has earned has not been used effectively, when measured against the other options that they have.
For example, if your favorite brand of drink was available from your local store for $2, then went on sale for $1, you would think that the drink was undervalued, and buy more than one. However, if you were visiting another part of town, and they had the exact same drink for $4, then you would recognize the drink as overvalued and you would not buy it.
The exact same logic applies to buybacks, but instead of drinks that are simple to compare, there are thousands of variables for management to consider.
Stock buybacks also fail when they are done for the wrong reasons. One of these reasons is when company executives start one in order to get earnings per share to rise, because their pay and bonuses are related to these metrics.
Stock buybacks are also a poor idea when companies use money borrowed from lenders or other creditors to repurchase stock. This is because loaned money comes with interest payments, which reduce the returns to shareholders because the loan and interest needs to be repaid before any benefit can be gained.
Finally, buybacks fail when they show a lack of imagination from management to expand the business or use the cash more productively. In the fast changing business environment we live in, there are many ways to effectively deploy cash, and a buyback is only one option. Not investing well with available cash can limit future returns and allow competitors to catch up and take market share and profits.
Blackout Period
U.S. companies are required to refrain from discretionary buybacks during blackout period that starts five weeks before earnings release to about 48 hours after earnings are reported. This is great opportunity for investors according to Goldman Sachs. In February of 2014 record buyback in the amount of $104.3 billion took place.
Goldman Sachs recommends AAPL, YHOO, SNDK and FFIV and few others as attractive stocks to buy during this blackout period.
Conclusion
Stock buybacks are a common business tactic when stock prices are rising and company profits are high and cash reserves increase. The decision to undertake a buyback is the result of a huge range of possible factors, and each one is different. To get a good understanding of how a buyback will affect a particular stock, it pays to have access to a regular options advisory newsletter like the one we produce at Financial Markets Wizard that can explain it clearly for you.