Corporate Stock Buybacks for Investors

When you read the financial pages, you sometimes hear that a company is buying its own stock from investors. Why would a company do that, and what does that mean to you if you own the stock or are considering buying it?

When companies buy back their own stock, they’re generally indicating that they believe their stock is undervalued and that it has the potential to rise. If a company shows strong fundamentals (for example, good financial condition and increasing sales and earnings) and it’s buying more of its own stock, it’s worth investigating — it may make a great addition to your portfolio.

Just because a company announces a stock buyback doesn’t always mean that one will happen. The announcement itself is meant to stir interest in the stock and cause the price to rise. The stock buyback may be only an opportunity for insiders to sell stock, or it may be needed for executive compensation — recruiting and retaining competent management are positive uses of money.

If you see that a company is buying back its stock while most of the insiders are selling their personal shares, that’s not a good sign. It may not necessarily be a bad sign, but it’s not a positive sign. Play it safe and invest elsewhere.

Why a company buys back shares

Why would a public company buy stock — especially its own?

Boost earnings per share

By simply buying back its own shares from stockholders, a company can increase its earnings per share without actually earning extra money. Sound like a magician’s trick? Well, it is, kind of. A corporate stock buyback is a financial sleight of hand that investors should be aware of.

The important point to keep in mind about stock buybacks is that actual company earnings don’t change — no fundamental changes occur in company management or operations — so the increase in EPS can be misleading. But the marketplace can be obsessive about earnings, and because earnings are the lifeblood of any company, an earnings boost, even if it’s cosmetic, can also boost the stock price.

If you watch a company’s price-to-earnings ratio, you know that increased earnings usually mean an eventual increase in the stock price. Additionally, a stock buyback affects supply and demand. With less available stock in the market, demand necessarily sends the stock price upward.

Whenever a company makes a major purchase, such as buying back its own stock, think about how the company is paying for it and whether it seems like a good use of the company’s purchasing power. In general, companies buy their stock for the same reasons any investor buys stock — they believe that the stock is a good investment and will appreciate in time.

Beat back a takeover bid

A hostile takeover means that one company wants to buy enough shares of the other’s stock to effectively control it. Because buying and selling stock happens in a public market or exchange, companies can buy each other’s stock.

In some cases, the company attempting the takeover already owns some of the target company’s stock. In this case, the targeted company may offer to buy those shares back from the aggressor at a premium to thwart the takeover bid. This type of offer is often referred to as greenmail.

Takeover concerns generally prompt interest in the investing public, driving the stock price upward and benefiting current stockholders.

The downside of buybacks

When a company uses funds from operations for the stock buyback, less money is available for other activities, such as upgrading technology, making improvements, or doing research and development.

A company faces even greater dangers when it uses debt to finance a stock buyback. If the company uses borrowed funds, it has less borrowing power for other uses and also has to pay back the borrowed funds with interest, lowering earnings figures.

Using debt to finance a stock buyback needs to make economic sense — it needs to strengthen the company’s financial position. Because debt interest ultimately decreases earnings, companies must be careful when using debt to buy back their stock.

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