Stock Buybacks, The Pros and Cons Examined

Posted on Fri 22nd May, 2009 05:19:15 PM

A stock buyback, also called a share repurchase, is the process of a company buying back its own shares from the marketplace. In the process the company reduces the number of shares outstanding and adds to its own position in its company stock.

Stock buybacks are generally conducted either by a tender offer or through the open market. A tender offer stock buyback program will have stipulations on exactly how many shares the company will repurchase as well as what price the company will purchase the shares. If the company decides to go about the stock buyback program through the open market then they act as any normal investor would, buying shares at the price they are available in the open market. Most often companies will choose to act as any normal investor would and purchase shares of stock through the open market.

Why does a company buyback their own stock?

The motives for a stock buyback are wide-ranging, and the precise motives for buying back the stock are often never known by the common investor. Stock buybacks have typically been seen in a positive light, but over the last few years more and more people have begun to question buybacks as a strategy to create value for shareholders. Is it really the best way a company can spend their money? Let’s take a closer look at some of the pros and cons of stock buyback programs.

Stock Buyback Pros:

A company that is buying back its own stock usually believes the stock is undervalued and believes it is a good buy. This is obviously a good sign for shareholders because the company is basically betting on their continued success.
Stock buybacks create a very nice price support level for investors. This is especially true in recessionary periods or bear market periods. A stock that has a massive stock repurchase program going on will have that extra price support that can serve as a safety net for investors in the stock.
Buying back stock means less outstanding shares, which means higher earnings per share number if all other things stay equal. A higher EPS number is always important in the market.

Stock Buyback Cons:

Serve as an easy cover up for poor financial ratios at the company. A company can buy their own shares and create an artificial lift in their financial ratios which makes market observers believe things are improving, even if they are not.
Allow the company insiders to take advantage of stock option programs while not diluting the overall EPS number that is reported to the market. Warren Buffett has noted on several occasions that he believes employee stock option programs and buyback programs can be quite shady.
Typically creates a quick and often artificial jump in the price of a stock. Advantageous insiders then quickly sell at a higher price while individual investors tend to be late buying into the stock and buy in at high price levels. Long-term prices haven’t been directly correlated to share repurchase announcements, but in the short-term stocks often bounce in a big way.

As you can see there are certainly two sides to the argument of what a stock buyback means for a stock and the individual shareholder. The prevailing thought on the street has generally been that it is a positive when a company decides to invest in itself, but over the last few years there have been more questions raised as to the motives for share repurchase programs. Simply put there is no right or wrong answer as to whether a stock buyback is a positive or negative for a stock. While it may be difficult to hear since many investors want a direct answer, the true answer depends upon the individual case.

As an investor it is important that you understand the basic definition of a stock buyback and what that repurchase program can mean for the company as a whole. Consider the financial position of the company that has announced the share repurchase plan and whether it is already in strong standing. A company that is mature and already has a strong financial position and a healthy dividend may well have good intentions for the company and the shareholder when buying back their own stock. A company with poor financial ratios and shady recent earnings results that announces a stock repurchase should be looked upon with much more trepidation. The next time you see a stock buyback announcement; take a close look at the company involved before making a final determination of what it may mean for the future of the stock.

Aaron K. Smith is a freelance writer with experience working in the mutual fund industry and writing about investing and the stock market. View all posts by Aaron.

Other Popular Posts: