Why Stock Buybacks Are Significant

As the name implies, stock buybacks (also known as share repurchase programs) happen when companies buy back their own shares. A firm uses its cash position to repurchase company stock either in the open market or directly from select shareholders. These programs reduce the number of shares outstanding for the company in question and thus increase the ownership stakes of its remaining shareholders. The end result is more profits or earnings per share (EPS) per shareholder.

In general, stock buybacks are viewed favorably by Wall Street.

These programs help neutralize shareholder dilution that comes from excessive stock option issuance. Many management teams go further and announce buyback programs that more than offsets dilution from stock options. In these cases, existing shareholders see their ownership stakes grow, and with it, their portion of earnings per share.

Another positive attribute of share buybacks is their effect on key company financial metrics such as earnings per share (EPS), return on equity (ROE), and earnings growth rates. These ratios are used by professional investors to determine the health of a company and are usually part of their investment decision process. Because stock buybacks often boost a company’s financial profile, these programs can lead to more interest among institutional investors and thus increased demand for the stock. Higher demand from large investors typically translates into a higher stock price. With higher ownership stakes and larger earnings per share accruing to remaining investors, stock buybacks offer shareholders a compelling, two-fold benefit.

Investor perception also plays a significant role in stock buybacks.

Many argue that because a company’s management team has inside information regarding a firm’s growth prospects, a share buyback announcement is a signal that a stock may be undervalued – otherwise management would choose to spend the company’s cash on more profitable investments. This positive signal alone can cause a stock’s price to rise.

There is a downside to stock buybacks, however. In recent years, record-low interest rates have prompted many companies to issue large amounts of debt to fund their share buyback programs. While this has had the effect of boosting near-term earnings growth and increasing existing shareholders’ ownership stakes, it could come at the cost of longer-term returns. Although interest rates remain low, as yields increase- debt servicing costs are likely to rise. These higher debt burdens – taken on to buyback company shares – could crimp a company’s ability to invest in value-enhancing initiatives such as technology investments or new manufacturing facilities, and ultimately reduce long-term earnings and cash flow growth.

Likewise, stock buybacks are a more flexible alternative than issuing a dividend. Many contend that management teams prefer share repurchase programs to dividend payments because they can easily suspend buyback activity with limited negative ramifications. In contrast, dividend cuts are viewed quite unfavorably by investors and are likely to significantly pressure a stock price. When a company issues a new dividend it suggests confidence in the firm’s market position, growth prospects, and cash flows. Thus, when dividends are cut or eliminated it signals deteriorating company fundamentals ahead.

Given the short-term benefits and minimal near-term risks associated with share buybacks, more companies are engaging in these programs than ever. Similar to individual investments, repurchase programs are most beneficial when a management team buys its firm’s stock at low levels and watches it appreciate in value over time. Although the investing principle of buy low and sell high is well understood, many corporate directors fail to follow this basic rule of thumb. The historical record indicates that seasoned company management teams are just as likely to buy at peak valuation levels and refrain from share buyback programs at market bottoms.

Although company management teams have a poor track record when it comes to timing share buyback programs, many are excellent stewards of their firm’s growth prospects and market positions. This suggests that as individual investors we would do best to focus on high-quality investments with long-term track records of delivering value and leave the market timing to speculators.