“Why Do Companies Buy Back Stock?” It’s a very good question, especially since there is so much confusion and misinformation around why companies do buy back stock.
So, read this short blog post to learn why companies buy back stock… as well as when it might signal a profitable investing idea… or when it indicates a dangerous decision by management.
Companies Buy Back Stock To Increase Share Price
The main reason companies buy back their stock is because they want to increase their share price. Whether or not this works might be a different story. But remember…
Stock markets work based on simple economics. When a company buys up all of it’s shares that means there are fewer shares available in the float for everyone else. Less supply means more relative demand, so stock prices should go up. Make sense?
Great. So here’s where corporate stock buy backs get a little more fuzzy… you see… While buying back stock makes sense for companies some of the time (see below), it’s not always the best choice. Why’s that?
Try to keep in mind (1) Business is about generating cash-flow and (2) Management is always under pressure from shareholders to reinvest that cash flow into the business and create more shareholder value. Buying back stocks is simply one way to do this. High dividends are another approach companies use to distribute free cash.
But when companies buy back their stock how do you know it’s the best use of that hard-earned cash?
When Companies’ Buying Back Stocks Is a Good Thing:
Believe it or not, sometimes companies buying back their stock can be a great use of free cash. The main reason for this is that despite all the hype about efficient market theory, the stock market is inefficient in the short term. Sometimes (especially after harsh bear markets) a lot of stocks become undervalued. This is a prime opportunity for companies to buy back their stock.
Here’s why companies should buy back their stock after sell-offs:
If management feels strongly that the shares of the company are very undervalued by the public markets, relative to the intrinsic value of the business then they should use excess free cash to buy stocks. For example, if a stock has been languishing at 52 week lows and trading significantly below the net assets of the company/share — then management might initiate a stock buyback to shake things up. This buyback is a good investment for the company because while the stock market might be undervaluing the company, the company can redeem these shares at a discounted price to their true value. As the company continues to execute on its growth objectives and meet earnings targets the stock will go up in price. As the market cap of the company increases the per share value will go up even more as their are less shares outstanding since management gobbled up the extras in a buyback.
You might need to read the above paragraph again to truly understand when it’s a good time for companies to buy back their own stock. But the logic isn’t too tricky. One hint can be that often times you will see famous value investors buying stock alongside company stock buy backs. In these cases, you may want to buy the stock of the company along with insiders. That’s because the corporate buying puts a floor in the stock price. When a company announces a share buy back they are basically announcing extra demand for the stock. This announcement of a share repurchase itself can be enough to get the stock moving.
But companies aren’t always doing the right thing when they buy back their stock. So now that you know why a stock buyback can be a good thing, here’s why you need to be careful of companies buying back their shares…
When Stock Buy Backs Don’t Help a Company:
Companies buying back their stock might be pursuing a diligent use of extra free cash flow. But you need to be careful because sometimes nefarious executives will try to issue stock buybacks when it might not be in the best interest of the company. There are two main circumstances that come to mind when stock buy backs are a bad idea for companies…
(1) Companies buy back their stock because they’re lazy: As you learned above, companies buy back their stock because they are under pressure from shareholders to redeploy cash. In fast growing or capital intensive industries there is usually enough demand for capital from the business itself that management needn’t worry too much. For example in those cases management might need to invest in growing the company’s salesforce or repairing and maintaining plant and equipment… so there is lots of use for cash. But in non-growing, less-capital intensive businesses, management might have trouble finding high return uses for the cash flows. In this case, they might issue a buy back of stock because they don’t have a better idea. While this might be a reasonable idea in the short term, slashing R&D budgets often deteriorates the long term growth prospects of most companies. And that brings us to the next point…
(2) Corporate Objectives Are Not Always Aligned With Shareholders: Sometimes companies buy back their stock because it is in the interest of management. And while management should be obligated to maximize shareholder value, that doesn’t always play out as planned. For example, if executives have short term options that expire in the next couple of years, they may be under pressure to get the quarterly earnings numbers up. Instead of pursuing risky new growth objectives or striking new distribution deals, management might just choose to buy back stock. If they buy back stock without consideration for the intrinsic value of the business (but to pump earnings and exercise their options in the money) then this is not in the longterm interest of the shareholders and you may want to inquire about the executive compensation happening at your company in question.
Of course there are other answers to the question, “Why Do Companies Buy Back Stock?” But this should give you enough information to start sniffing around when companies announce share repurchases and determine for yourself if it will benefit shareholders (read: you) or not…
How Do you Calculate Intrinsic Value In Share Buy Backs?
So you’ve learned companies buy back shares because they want to raise the price of their stock. And you’ve learned when buying stock back is a good thing and when it is a bad thing. So only one question really remains… how do you actually figure out if the intrinsic value of the company supports the decision to purchase shares?
Well, that’s a pretty complicated question. But one quick proxy you can use is book value. This is very quick and dirty in terms of calculations, but if the stock is trading below book value there might be value in having the company buy back stock. So make sure you take a quick look before you blindly follow companies who are buying back their stock. If you’re looking for where to find companies that are buying back their stock, just watch this short video below:
Companies Who Buy Back Their Stock [VIDEO]:
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