Share buybacks - good and bad Explained

  

Whether you've just started investing or you've been in it for a while, you've probably heard at one point or another about the share buyback. An activity companies carry out to return their profits to investors. On the surface, it probably seems like a simple enough mechanic. I mean the name itself seems to tell you all that you need to know. But buybacks carry many implications for those invested in the company. 

In some circumstances, the process can benefit shareholders and it's a great and fairly efficient way for a company, to pay out its earnings to those invested in the firm. In others it actually destroys shareholder value and can be used to manipulate accounting figures, to boost executive pay. clearly, it's a more complicated and controversial topic than you might have expected. In fact, we've even seen American banks banned from carrying out buybacks by the u.s federal reserve during this pandemic. so what is the share buyback? what does it mean for investors? and is it a good or a bad thing? well, we'll answer those questions and more in this article.

The share buyback as the name implies is when a corporation buys back its shares from the open market. thanks for watching. Okay, there's admittedly a bit more to it than that. But the process itself is fairly straightforward. As a company makes money throughout the year they may decide to take some of their excess cash to purchase their own shares. They might do this through a tender offer where they solicit their existing shareholders with a specified stock price. And ask those interested to sell them their shares or like other investors, they may just go to the market and place buy orders on their own ticker. 

Now, this shouldn't be confused with the company's management buying the stock. executives may accumulate shares of the company they run by investing their own money or through a compensation arrangement with their corporation. But the shares from a buyback are not going to any individual's personal investment account. instead, the shares purchased through a buyback are actually absorbed by the company and cease to exist. in other words, a buyback removes the shares from the market as a whole and reduces the total number of shares outstanding that investors can now buy or sell.

 Why would a company do this? well while eliminating shares might not appear particularly productive, it actually increases how much other shareholders own of the company. After all, each year represents a fractional ownership of the corporation. By reducing the total number of shares outstanding, the company is increasing the stake of the remaining investors. 

For example, imagine you're an investor who owns 100 shares of company A. The company has a total share outstanding count of 1 million shares so you currently own 0.01 of the firm. now imagine the company were to buy back half of its shares, reducing the shares outstanding by 500,000. All of a sudden you as a shareholder now own 0.02 percent of the company. Sure it might not sound like a lot but you've doubled your ownership of company A. With fewer shareholders laying claim to the company your share of the pie has now increased. Well, it might not seem it this process is actually fairly similar to a company paying off its debt, while equity isn't really a liability. The company is in effect paying off existing investors so that they relinquish their claim over the firm. which reduces the number of people who control the company. 

However, a company will only buy back its shares when it doesn't have a better use for the funds. if a company has the opportunity to invest in a project that will double operations, it may keep the money to expand its business. In the same way, it might be a good idea for them to take out a fairly low-interest loan. But if they're instead more mature and don't really stand to benefit from an extra manufacturing plant or sales outlet, then a buyback is an effective way for them to transfer their profits to shareholders rather than blowing the money on some unnecessary venture. 

Now you might be thinking that this sounds a lot like a dividend, which is when a company pays some of its profits directly to investors because it doesn't have a better use for the money. And you'd be exactly right. in fact, share buybacks are considered to be equivalent to a dividend under certain assumptions. From the company's perspective, it doesn't really matter whether they pay out a dividend or use the same money to buy back their stock. Because both involve taking their after-tax profits and giving the money to their investors. It also doesn't really matter from the investor's standpoint if they receive the dividend and decide to reinvest it back into the company. Then the result is nearly identical to the outcome of the buyback. 

In fact, when you consider taxes, share buybacks actually have a bit of an advantage. Dividends after all experience double taxation. The money is first taxed at the corporate level when it's earned by the business through profit and then again at the investor level when it's received as income. With a share buyback, however, money is not directly passing through to the investor. So they can experience a similar benefit without being charged personal income tax right away. You can see why many investors love to buyback. But their benefit goes past increase in the existing shareholders' stake. Share buybacks also improve a firm's financial ratios. namely, their earnings per share. An important gauge of a stock's profitability. For example with company A, imagine that the company is consistently earning 100 million dollars a year. Split across 1 million shareholders the stock has an earnings per share of 100. After carrying out the buybacks, however, this would increase to 200 a share. The company hasn't earned any more money but with fewer people to split the profits across. Their earnings per share have now doubled.

 Finally, there's actually some evidence that share buybacks can boost the stock's price. Not only is the company now inserting itself into the market as a buyer, for its share which as supply and demand dictates will increase the price. But buybacks are viewed as a positive signal. meaning that they are often interpreted as a positive sign that operations are going well. After all, management buying back their shares sort of implies that the company has enough cash to spend and that management believes that the stock is a good investment. And hey if a company is willing to invest in their self why shouldn't other investors? it's why many investors actually screen for companies that are decreasing their share count over time. And why warren Buffett himself has often praised the buyback.

 But while this has led many to covet the activity, the truth is that it's not always a good idea. Sure a buyback can be a sign of a diligent management team returning capital to their shareholders in a fairly efficient manner. But in other circumstances, it can actually be a waste of money and in some cases can even be used for more devious purposes. 

To start off share buybacks are really only beneficial when the stock's price is undervalued. as you know investors are always looking to buy low and sell high. And in practice, we want the companies that we have our money in, to follow that same mentality. A company should only buy back its stock when it believes that the stock price is undervalued and lower than what it should be.

 For example, imagine you had two identical companies with 100 million shares outstanding. The first company's stock has recently dropped in price it was trading at 10 a piece. But after reporting a year of slow sales growth, it's now at five dollars a share. The second company meanwhile has had an abnormally strong year and its stock price has increased from ten dollars to fifteen dollars. Now if both companies want to carry out a share buyback of 10 million dollars, you'll see that the impact varies pretty drastically. For the first company because the stock price is so low management is able to buy back two million shares reducing their shares outstanding by two percentage points. A pretty good result for romanian investors. For the second company, however, the same amount of money is only able to buy back around 0.7 percent of the shares outstanding. because the company is paying a premium for its shares. T

he buyback as a whole isn't as effective at reducing the share count and yet we'll often see companies buying back shares even after their stock price has risen. For some, this may reflect management's confidence that the business has much more room to run. But sometimes companies will simply carry out share buybacks because investors have come to expect them and pulling back now could hurt the stock's price by providing a negative signal to investors. With some assuming that management is now less confident than they used to be. management may also simply be overconfident believing there's nowhere to go but up even if the fundamentals don't really justify that buyback. And sadly management will sometimes carry out buybacks out of self-interest.

 Imagine for example that a management team has its compensation tied to their company's earnings per share. And in a given year the company sees its net income fall. The company is strapped for cash and really isn't well equipped to carry out a share buyback. But a buyback could boost eps to the point where management reaches their growth target and unlocks bonus compensation. So the managers may be tempted to take money from other areas to fund a share buyback. bolstering the stocks earnings per share, but meanwhile hurting their operations. Just to unlock these special bonuses that they clearly don't deserve.

 As you can see there are some situations when a buyback is less than ideal.  This is part of the reason why we saw the federal reserve ban banks from carrying out buybacks in the US. There was concern that the banks would put money towards buybacks that should be going towards other activities such as building a rainy day fund. Nonetheless for value investors share buybacks are sort of viewed as a broadly positive thing. If you like a company and think it's undervalued then why wouldn't you want to see your stake in the company increase? But there are other factors you need to consider. Some investment theory even argues that share buybacks are a moot point for investors.

 So while you might like to see a company's share count declining, make sure the company is justified in its action. If you want to gauge a company's buyback activity you can check out their cash flow statement, where you'll see how much money the company has spent or alternatively raised by buying or selling their own shares. We should also view the share buybacks in conjunction with the company's balance sheet strength and their stock's valuation to ensure it makes sense for the business. 

So as with most things in investments, not all that glitters is gold and there's no clear-cut rule when it comes to share buybacks. While the client share count can be a pretty nice thing to see, even as a value investor I'd much rather put my money into a company diluting its share ownership for a good reason, than a company buying package shares for a bad one. Stock buybacks are just an example of one of those concepts, that while important to the investor isn't that widely understood. 

And the truth is if you're going to pick and choose your own stocks you need to understand the intricacies of the investment vehicle, the business and the economy. This is actually one of the takeaways of the book outsmarting the crowd by Bogomil Baranowski. A book that covers value investing at a high level and if you're interested in checking it out, you can actually read it on Blinkist.

Blinkist is an app where subscribers can read or listen to summaries of non-fiction books. Key lessons are highlighted in short clips and segmented in the blinks, which makes it great for those with only a few minutes to spare. I use it mostly when I'm doing chores around the house. so it's nice being able to learn something new while doing a menial task. Books on the platform cover a wide array of topics from psychology to communication skills to science and they have a number of good investment reads on there too. the one I always highlight is the intelligent investor written by the father value investing himself benjamin graham and if you want to go through the whole book rather than just the Blinkist summary, it's available via audiobook as well something premium members get a discount on. so if you're interested in reading up on investing or anything checkout Blinkist.

Thank you for reading. If you have any feedback or suggest what I should cover in the future, let me know in the comments below