Stock buybacks occur when a corporation uses available cash to repurchase shares of itself either from shareholders or from the market in which available shares circulate. There are a number of advantages to stock buybacks, however there are also a few disadvantages. Knowing and recognizing when a stock buyback is genuinely good for a company can help distinguish between the pros and cons of stock buybacks.
Pros of stock buybacks:
• Reduces dilution of shares
Unless a company is about to reissue a different class of shares or resell shares at a future point the medium to long-term affect of share repurchases is a reduction of outstanding available shares. Investors tend to favor stock repurchases because the affect is usually a dilution of available shares which can increase both price and demand.
• Can increase Earnings Per Share (EPS)
When a share repurchase takes place, Earnings Per Share (EPS) can increase. This means a higher percentage of a company’s retained income is proportional to the outstanding shares of that company. For example, Company A reduces its shares from 1 million to 500 thousand, and its income is $10 million in the fiscal quarter before and after the share repurchase. Before the share repurchase EPS is $10 per share; after the repurchase, EPS is $20 per share.
• Lessens risk of corporate raiders
If a company is both profitable and undervalued the threat of an aggressive acquisition of that firm may increase via purchase of a controlling amount of the company’s shares by another company or investor(s). To avoid this, the company may realize its shares are deal and buy them back to both obtain a future profit on the shares and to avoid an aggressive takeover by a third party.
Cons of stock buybacks:
• Increased opportunity cost
Share repurchases aren’t always good according to Investopedia, a Forbes Corporation. This is because the money used to buyback shares may have a more optimal use that could create a Higher Return on Assets (ROA) and EPS. For example, if a company’s earnings remain the same with a share repurchase, EPS rises, but if the company’s earnings rise yielding an EPS higher than EPS after the stock buyback, then the share repurchase is less advantageous.
• Higher debt ratio
Even though share repurchases can have a positive affect on some financial metrics, it can have a negative affect on others. For example, a reduction in shares by 500,000 from 1 million in a company that has $1 million in total debt will lead to an increase in the company’s debt ratio. This means the company becomes more of a credit risk when it seeks to borrow capital due to less assets from buying the shares.
• Shrinking company
If a company’s earnings experience a simultaneously and proportionate drop in relation to the share repurchase, the affect of the share repurchase will be nullified in terms of Earnings Per Share. In such case the share repurchase is indicative of a shrinking company because not only have the number of shares been reduced, so have the amount of available assets and income. So with lowered earnings EPS stays the same or lowers, ROA decreases, and the debt ratio increases.
Understanding corporate motives for share repurchases is important in knowing if the stock buyback will be a pro, rather than con, for the company. To do so involves studying the industry sector, market conditions, revenue and earnings trends in addition to price movements of the share price among other things. If the financial indicators point to the share repurchase being a pro, then it is more likely to benefit stockholders.
1. http://bit.ly/boNRw8 (Businessweek)
2. http://bit.ly/a7EWJY (Investopedia)
3. http://bit.ly/aI416j (Rightline)
4. http://bit.ly/9xAqHI (Langsdorf)