The Pros & Cons of Share Buybacks

More often than not, Share buybacks are looked upon as a positive catalyst that the company thinks that the prices are undervalued at current levels and they are confident in the prospects further ahead. 

Furthermore, Share Buybacks reduce the company's outstanding shares so that the EPS (earnings per share) are accelerated with the "pie" being shared among lesser people. This enhances the assurance for investors to invest in the company; fuelling the increase of the stock price advancement.

However, there is always two sides to a story and there are downsides too. Let's examine some of the potential benefits and pitfalls of a stock buyback:

Benefits of Stock Buybacks

  • Increased Shareholder Value - There are many ways to value a profitable company but the most common measurement is Earnings Per Share (EPS). If earnings are flat but the number of outstanding shares decreases. . Voila! . . A magical increase in period-to-period EPS will result.
  • Increased Float - As the number of outstanding shares decreases, the shares remaining represent a larger percentage of the float. If demand increases and there is less supply, then fuel is added to a potential upward movement in the price of a stock.
  • Excess Cash - Companies usually buy back their stock with excess cash. If a company has excess cash, then at a minimum you can bank that it doesn't have a cash flow problem. More importantly, it signals that executives feel that cash re-invested in the corporation will get a better return than alternative investments.
  • Price Support - Companies with buyback programs in place use market weakness to buy back shares more aggressively during market pull-backs. This lends support to the price of the stock and ultimately provides security for long-term investors during rough times.
Potential Pitfalls

  • Manipulation of Earnings - Above, we described how a buyback improves the earnings per share number. Companies which have flat growth can possibly manipulate the EPS and appear to beat consensus estimates that were based on a larger number of outstanding shares.
  • Execution of BuybackThere is a difference between announcing a buyback and actually purchasing the stock. Unfortunately, there are cases where buyback announcements are made but not implemented entirely. It may initially boost the price of a stock, but this phenomenon (when it occurs) is usually short lived.
  • High Stock Prices - Re-purchasing shares at all-time high prices are highly risky and doesn't make a whole lot of sense unless there is something in the works that will add substantially to earnings. A classic example is AIG: It bought back shares at prices close to $1,500 during 2004-2007, only to see its stock fall to under $35 before the end of 2008.

Stock buyback programs can be really positive for stockholders if done at the right price and shows a wise use of excess cash when there are no alternatives for better capital allocation. Just keep a watch out of potential hazards like management seeking to cover up weak ratios or poorly managed employee stock option plans.

In my next post, I shall write about 3 well-known companies (Osim, Ho Bee, Sakae) which have performed consistent share buybacks and how their share prices have risen consequently.

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