Look closely when a company buys back stock

 

Investors love corporate stock buy-back programs. Even a repurchase plan announcement is enough to send a company's stock price higher. Investors often assume that the firm sees good things happening inside the company that are not fully reflected in the market price of the stock, suggesting that the shares are a bargain.

Be careful though. Companies buy back their shares for many reasons and some of them may be contrary to the interest of shareholders. Here are a few examples: 

Bolster the stock price. Repurchase programs tend to place a floor under the price of most stocks. That's because there is now a large buyer in the market.

However, corporate assets are being used to prop up share prices. If management were to allocate those assets in more productive ways, perhaps the share price would not need bolstering.

Increase book value. Book value is calculated by subtracting total liabilities from total assets. The book value per share will rise in a stock buy-bak, but only if the price paid for the stock is less than the book value per share

Increase earnings per share. Earnings per share will rise due to a stock buy-back program.

For example, XYZ company, which trades at $40 per share, has $100 million in annual profits and 50 million shares outstanding, has earnings per share of $2 and a price-to-earnings ratio of 20.

The company, which is cas-rich $125 millio in the bank, buys back one per cent of its stock at $40 per share. That's 500,000 shares or $20 million.

As a result, the same profit of $100 million is now spread over 49.5 million shares, giving earnings per share of $2.02. In effect, earnings went up one per cent, the same percentage as the reduction in the number of shares.

The real question about buy-backs should be: Is this the best use for your company's money? Could the company have received a higher rate of return if it had invested in some other asset besides its own stock?

There is a simple equation you can use to figure this out.

First, divide the stock's price-earnings ratio into 100. Our company has a price-earnings ratio of 20, so we end up with five per cent.

If the. company could invest its assets and receives a higher rate of return (in this case, higher than five per cent), then it should not repurchase shares of its own stock. It should instead invest the $20 million to maximize shareholder return.

Reduce taxes. The tax issue might persuade some to prefer stok buy-back programs over dividends. But it does not address why the corporation or the investor would prefer stock buy-back over alternative investments that could earn higher returns than a stock repurchase.

Employee incentive options. Often companies run out of stock to award as employee incentive options. If the company is buying stock at market price to sell to the manager's pool of employee incentive optins, it might make a convincing argument.

 But it's not. Shareholders can always authorize additional shares at the next annual meeting.

Hostile takeover protection. Cash-rich companies are tarjets for takeovers. tock buyback programs reduce cash, thus making a corporation less attractive. Enough said.