Finance Learning - Stock Buyback

A Breakdown Of Stock Buybacks

excerpt as follows :
A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the marketplace. You can think of a buyback as a company investing in itself, or using its cash to buy its own shares. The idea is simple: because a company can’t act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company.

2. Open Market The second alternative a company has is to buy shares on the open market, just like an individual investor would, at the market price. It is important to note, however, that when a company announces a buyback it is usually perceived by the market as a positive thing, which often causes the share price to shoot up.

Nevertheless, there are still sound motives that drive companies to repurchase shares. For example, management many feel the market has discounted its share price too steeply. A stock price can be pummeled by the market for many reasons like weaker-then-expected earnings results, an accounting scandal or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it says management believes that the market has gone too far in discounting the shares - a positive sign.

Another reason a company might pursue a buyback is solely to improve its financial ratios – metrics upon which the market seems to be heavily focused. This motivation is questionable. If reducing the number of shares is not done in an attempt to create more value for shareholders but rather make financial ratios look better, there is likely to be a problem with the management. However, if a company’s motive for initiating a buyback program is sound, the improvement of its financial ratios in the process may just be a byproduct of a good corporate decision. Let’s look at how this happens.

Moreover, buybacks reduce the assets on the balance sheet (remember cash is an asset). As a result, return on assets (ROA) actually increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives. (See Reading The Balance Sheet.)

The buyback also helps to improve the company’s price-earnings ratio (P/E).

Based on the P/E ratio as a measure of value, the company is now less expensive than it was prior to the repurchase despite the fact there was no change in earnings.

Bull markets and strong economies often create a very competitive labor market - companies have to compete to retain personnel and ESOPs comprise many compensation packages. Stock options have the opposite effect of share repurchases, as they increase the number of shares outstanding when the options are exercised. As was seen in the above example, a change in the number of outstanding shares can affect key financial measures such as EPS and P/E. In the case of dilution, it has the opposite effect of repurchase: it weakens the financial appearance of the company.

In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate, whereas dividends are taxed at ordinary income tax rates. However, with the passing of the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate on dividends is now equivalent to the rate on capital gains.

Conclusion
Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback - and its effects - can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution.

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