This Is What Happens in a Stock Buyback: Challenge the Fundamentals
Stock Buyback or Stock Repurchase Defined
A stock buyback or stock repurchase is the purchase of company shares by the same company that issued them. The company purchases its own shares in the stock market in the same way that you would do so when buying shares in that company.
As this article is directed to the average investor in the stock market, as well as the average man-in-the-street or more commonly known as the layman stock investor, I will try and confine my discussions to how it affects this group of people
While stock buybacks have benefits and disadvantages for both the stockholder and the mother corporation, I will delve more into the effects it has on the shareholder rather than the corporation.
Same Marketing Principles of Supply & Demand
By buying back its own shares in the open market a company is in effect redeeming some of its outstanding shares or acquiring shares that are floating out in the general public. This decreases the number of shares available to the public which hopefully results in a rise in the market price of the stock—the basic workings of supply and demand. This, more than anything else, is the primary objective of a buyback program.
Why a Company Buys Back Its Own Shares
When a company is first formed it sells shares of stock to investors who then become percentage shareowners of the newly formed corporation. In similar fashion when an existing company requires more capital, for whatever reason, such as financing operations, funding expansion projects, launching a new product, acquiring another company, etc, it may borrow money from financial institutions paying high-interest rates. Or, it may sell additional shares to the public to generate the needed cash funds.
Conversely, when a company is doing financially well and has too much excess cash in its coffers that are not immediately needed, it may repurchase or retire some or all of its own shares.
There are many reasons why a company would want to repurchase its own company stock. Some of the more important ones are:
1. Instead of paying out additional cash dividends from its excess cash reserves, it may elect to buy back its shares which is one way of rewarding shareholders. It serves as a monetary bonus to shareholders without having to promise continuity of payments.
2. A buyback program may be a sign that the company’s stock market price may be undervalued and it feels it is worth investing in itself.
3. As a defensive play to prevent hostile takeovers from undesirable suitors. Buying back shares could result in the share price of the company to appreciate enough to discourage the prospective suitor.
4. Increases a company’s earnings per share ratio – EPS – which may increase its stock price, although this is a kind of window dressing.
There are yet other reasons that a company would want to buy back its shares but I will not mention them here since they are for more complicated financial reasons that may be too intricate to understand for the average layman investor.
The motivations mentioned above also serve as the benefits that accrue to the shareholder in a buyback program. Here is how it works.
How the Shareholder Benefits From a Buyback
When a company buys back its shares it almost automatically results in a rise in its share price in the stock market. See paragraph below "Buyback May Increase Stock Price." This may the first direct benefit of a buyback.
Looking at the table below for McDonalds Corporation’s financial results for a three year period, we see the stock price at the beginning of the year 2015 at $94.25. At the end of the year, the price has escalated to $119.43.
Because of share buybacks and perhaps other favorable factors, the stock price steadily went upward. At the end of the year it was at a high of $119.43 per share. Assuming you had 200 shares of MCD, you could have paid yourself a dividend bonus by selling some shares at the much higher price.
This however, reduces your ownership share in the company since you’ve surrendered some of your shares. This could be a disadvantage to you if the company does not increase its regular dividend payments because you will now receive less dividend money for the lesser quantity of shares you own.
Buyback May Serve To Increase Dividends Per Share
Having said this, it usually happens though that the company will increase its dividend rate due to the lesser number of shares floating in the market. In the end you have received a bonus from the sale of some of your stock plus you continue to receive the same amount of money in regular dividends. As you can see in the table presented below MCD increased its dividend per share rate on each of the years 2013-2015.
Using another example, let’s assume that XYZ Company earned $10 million from its operations. The company has a policy of allocating 10% of its earnings to pay out cash dividends and it has 500,000 outstanding shares. This translates to $2.00 cash dividend per share ($10 million x 10% ÷ 500,000).
Assuming the company, prior to paying dividends, bought back 100,000 of its own outstanding shares. This would reduce the number of floating shares down to 400,000. If the company maintains the same percentage of 10% dividends on its earnings of $10 million then the cash payout for each share would now be $2.50 computed as follows: $10 million x 10% ÷ 400,000.
Buyback Offers Tax Benefit
This is one of the big benefits offered to the shareholder by a stock repurchase program. As every dividend receiving shareholder knows, dividends paid in cash by a corporation are taxed as regular income to the recipient. But if you sell stocks and make a profit in the sale your profits are taxed as capital gains under more favorable rates.
Let’s go back to the example of you having 200 shares of MCD stock which you have held for more than one year. Let’s say your average cost of these shares, which you slowly accumulated over the years, is $85 per share. Let’s assume further that your net taxable annual income (after deductions) places you in the 25% tax bracket. This means you are taxed at 25% for all income received, including cash dividends.
But if you sold some of your shares at the current market price of $119 you would only pay 15% of capital gains tax on the profit you earned in the sale. In this case 15% of $34 ($119 less $85). So it may benefit you to sell some of your shares and pay the smaller tax rate on the capital gains. Your dividends received on the remaining shares will be taxed at the 25% bracket that you are in. But since you now have lesser shares the impact of the 25% tax may not be as bad.
Buyback May Increase Stock Price
Because a repurchase program reduces the number of shares in the market, this is tantamount to a retirement of outstanding floating shares. The capital value of a company divided by its outstanding shares returns a certain book value which is one of the determining factors in the price of a stock. This is referred to as the net asset value of the stock or NAV for short.
Another factor that influences stock price is the company’s earnings per share (EPS) which is the company’s earnings divided by the number of outstanding shares. These two components, NAV, and EPS by themselves may influence the stock market price of the company’s outstanding shares.
Example: XYZ Company has total net assets (net of liabilities and capital) of $10,000,000 and outstanding floating stock of 1,000,000 shares. The net asset value per share (NAV) is therefore $10 ($10 million divided by 1 million shares). Buying back 100,000 shares leaves a net stock float of 900,000 which then translates into a NAV of $11.11
In the same manner, XYZ Company with total net earnings of $500,000 would have an EPS value of $0.50 before a buyback. After repurchasing 100,000 shares the company’s NAV rises to $0.56 using the same method of calculation as above.
In the real world, these two factors are not the only ones that influence a stock market price. There is also the all-important element of supply and demand plus other relevant considerations that result in the final market price. Regardless, NAV and EPS play very important roles.
Effects of Share Buyback On Dividend and Stock Price Per Share
NOTE: The lower stock price at the end of 2014 was caused by factors not related to the buyback without which the stock price would have been higher.
After looking at the various possible scenarios where stock buybacks are beneficial to the stock investor, don’t be too enamored with the program until you’ve looked at potential pitfalls of the system.
A company that is buying back its shares may be intentionally doing so to artificially boost its market price for reasons that the investor should investigate.
Many companies pay their top executives high bonuses that are tied to how the company’s EPS performs. As has been demonstrated in the examples given, EPS can be window dressed by doing a stock buyback. It enhances the EPS numbers by making the company look more profitable when in fact it is not. This kind of window dressing can lead to a temporary boost in stock price with a subsequent drop a short time later.
A company can resort to a buyback when it has reached it maximum growth potential and no longer needs its cash resources for this purpose. Opportunities for further earnings growth may have reached its peak. This could be indicative of a stagnant or even a declining future stock price.
Investors should be especially wary of companies that buy back its shares when they continue to carry large amounts of long-term debts in their books.
There is an interesting article that appeared in USA Today in their November 14, 2015, issue. The title is “Stock buybacks are not always a good deal for investors”
To Sum Up
On the surface it would appear that a buyback program is a very good method of distributing a company’s accumulated wealth to its owners, the shareholders. The more popular method of distributing wealth to stockholders is in the form of dividends. But dividends do not increase shareholder value which buybacks can do.
However, as stated in this article there can be many reasons, positive and negative, why a company is buying back its shares. Investors should do some investigation for reasons behind the buyback, whether it is good or bad in the long term. It has been generally accepted in the investing world that buybacks are only beneficial in the short term. Its long-term effects are not all that great.
It has been generally accepted in the investing world that buybacks are only beneficial in the short term. Its long-term effects are not all that great.
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© 2018 Daniel Mollat