Get Smart about Share Buybacks
Since 1997, share repurchases have surpassed cash dividends and become the dominant form of corporate payout in the United States. Although a stock buyback is fairly common, the investing public often overlooks the potential value of these programs that can be used in their investing or trading analysis.
What is a Share Buyback Program?
A stock buyback, also known as a "share repurchase", occurs when a company buys back its shares from the marketplace.
Along with dividends and capital appreciation, stock buyback is a common way in which a company can return wealth to its shareholders.
Why do Companies Buy Their Own Stock?
A Company knows more about its future prospects than any Wall Street Analyst.
The reasons a company may participate in stock repurchase plans include (but are not limited to) the following:
Improve Financial Ratios: By reducing its publicly-traded shares, a company may improve a number of key financial ratios.
Undervalued Shares: A Buyback may reassure investors a company has confidence in itself and the future growth of its stock price.
Lack of Growth Opportunities: A company may feel its stock represents a better growth opportunity than other potential uses of its resources.
Why Investors Like Share Buybacks
The benefits of share buybacks are not limited to Corporations. Investors may also realize the following benefits:
Potential Tax Benefits: Traditionally, buybacks are taxed at a capital gains tax rate, whereas dividends are subject to ordinary income tax.
Potential Boost in Price: When there is a less available supply of shares, then an upward demand will boost share prices.
Potentially Improved Shareholder Value: When companies pursue share buyback, they essentially reduce the assets on their balance sheets thereby increasing their return on assets.
No investment strategy is without risk...investors should be aware of the potential pitfalls of investing in share buyback stocks:
Manipulation of Earnings: If the timing is right, companies could buyback shares and appear to beat consensus estimates that were based on a larger number of outstanding shares. So, watch out for announcements just prior to earnings.
Announcement versus Execution: There is a difference between announcing a buyback and actually purchasing the stock. A buyback announcement may initially boost the price of a stock, but the gain will be short lived if the announcement is not acted upon. Don't be fooled into believing that all announcements are implemented.
High Stock Price: Beware of a buyback program announced when a stock is at or nearing an all-time high.
The Bottom Line
Stock buyback programs take advantage of supply and demand by reducing the number of shares outstanding, increasing shareholder value and often the price of stock. In addition, they are often a wise use of excess cash and can create tax opportunities for the investor. However, not all buybacks are actually implemented so caution is advisable.