When a company announces its earnings, it will often give numbers such as revenues, earnings per share, gross margins, etc. It may also announce guidance for the coming year and a dividend payment. Recently, you may have heard companies announce (or expand) a stock buyback program. Let’s take a look at what this means.
Stock buybacks are when a company uses its excess cash to buy its own stock in the open market. Seems simple enough. But as the title of this blog may indicate, there’s more to it than just that. The reasons and ramifications of this strategy can cause disagreements as to its merits.
Two significant reasons to buy back stock are: 1. the company thinks its stock is undervalued, and 2. as a way to return cash to its shareholders. The first reason is pretty straightforward. When a company has excess cash on hand (i.e. more than is necessary for its operations), it needs to do something with it. Especially in today’s environment when short term investments are not paying very much. So, a company may consider many different alternatives and decide that buying its own stock is the best value.
The second reason is a little less intuitive. With its excess cash, a company can return capital to its shareholders by making a dividend payment. This is actual cash paid out on a per share basis. Alternatively, the company can buy back stock, which reduces the number of shares outstanding, which (in theory) should increase the value of each share. Let’s take a closer with a hypothetical company. (Here comes the math-y part)
Assume a company has ten equal owners. Each owner has 1,000 shares worth $100,000, so the company is worth $1,000,000 (10,000 shares @ $100/share). If the company makes $100,000, the earnings per share, or EPS, is $10 ($100,000 of earnings divided by total shares of 10,000). Further, the price to earnings ratio, P/E, is 10 (price of $100 per share divided by the EPS of $10). P/E ratios are a popular way to value a company. In this case, the market believes it is fair to pay ten times the earnings for this company.
Now, let’s say the company decides to buy back 1,000 shares with its excess cash. Nine of the owners say, “no, thank you”, but one decides to sell entirely. Now, there are only 9,000 shares outstanding. However, the company itself hasn’t changed (only the ownership). So, the $100,000 it makes is now divided by 9,000 shares to give it an EPS of $11.11. If the market still believes that this company is valued at a P/E of 10, then the new share price should be $111.10 (earnings of $11.11 multiplied by P/E of 10). This is why stock buybacks are a way to return capital to the shareholders. In the real world, where companies are dealing with millions or even billions of shares, the buybacks and the price adjustments happen gradually over time.
The Good. When corporate governance is working correctly, stock buybacks can be very beneficial to the shareholders. As a way to return capital to its shareholders, buybacks have a slight advantage over dividends because of taxes. Dividends are taxed in the year you receive them, however any increase in stock price because of a stock buyback would only be taxable if you sold your shares, as a capital gain. Also, when a company buys back its stock it is usually because it feels the shares are undervalued. This could be for a variety of reasons, but basically management is saying that investing in itself is the best thing to do.
The Bad. Using stock buybacks can create the illusion that a company is doing better than it is. You’ll notice that in the example above, even though the company has the same level of earnings before and after the buyback, the EPS has grown by 11%. ($11.11 v. $10). This is part of the “financial engineering” that I’ve talked about in the past. By reducing the number of outstanding shares, EPS can increase even if the company is not growing. Even worse, if the company’s shares are overvalued, then not only could the buyback be masking a valuation problem, but it also means the company is buying an overpriced asset.
The Ugly. Perhaps the worst consequence of stock buybacks, and what we’ve been experiencing in recent years, is that the excess cash being used is not being used to grow these companies. When a company decides to buy back stock, it is deciding not to use that money to hire more people, to open more facilities, or to do more R&D. These are actions that help grow our economy. Stock buybacks do not.
Some investors prefer to receive dividends over buybacks because it gives them control over the money. They would like to have the choice to reinvest in the company or not, whereas stock buybacks by definition are reinvestments. Others prefer buybacks because they don’t have to pay taxes on them and it shows confidence in the company. And, very often a company will do a combination of both. We’ve seen a steady increase in buybacks since the Financial Crisis. However, in the last year or so, this has tapered off. There are several reasons why this might be, but let’s stay positive and hope that companies are getting ready to deploy their cash in more pro-growth ways.
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An Investment Advisor registered through CUSO Financial Services, L.P., Gavin has 22 years of experience as an advisor in the Puget Sound area.
“I believe every client is unique and deserving of a personalized financial plan that will help them reach their individual financial goals. Before I make any recommendations, I like to get to know my clients. By asking the right questions, and developing an honest, trusting relationship I can really get a sense of what’s going to work best for them.”
Gavin graduated from the University of Washington with a BA in Business Administration and started his financial career with US Bank in the Investment Department. Prior to joining Verity in 2006, he spent eight years with Piper Jaffray.
So what is Gavin’s vision for his dream retirement?
“My dream retirement would be absolutely worry free: financially, emotionally, and in every aspect of life. My finances would be in order so expenses for travel, luxuries, and gifts for the kids, grandkids, and great-grandkids would be taken care of. My kids would be financially sound, so I would be confident in their prosperity. This would give me the freedom to travel and play and do whatever it is I want to do.”
When Gavin’s not working, he enjoys spending time with friends and family, watching Husky football, and taking weekend trips around the Northwest.
Gavin is registered to transact securities business in the states of WA, OR, CA, AZ, FL, HI, ID, IL, MN, NM, NY and VA.
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