Stock Buybacks

So today IBM announced that it was going to be buying back $15 billion worth of stock. In response, IBM rose nearly 4.5% (markets still haven't closed at this point, but it's getting late here in Europe). Moreover, the news actually helped boost the market amid worries of falling consumer sentiment and rising core wholesale prices (warning: stagflation).

So why is the IBM buyback important? Well, many saw it as a ray of hope in an increasingly troubled market. The news thus far has been pretty grim, and any sort of positive news is being put on a pedestal the market. However, there is a more fundamental reason behind why this news is positive, which I'll get to shortly.

A stock buyback is just that. The company buys back its own stock/shares. Just like a dividend, it's a way of returning wealth to the shareholders of the company. So, that's pretty good, but if that's all it is, why is there such a generally positive, sustained reaction to the announcement of a share repurchase. Well, think of it this way. In a stock buyback, the company takes spare cash it has lying around (or even sometimes issues new debt to raise cash to buyback shares) and reinvests this cash in itself, by buying back shares. This action essentially reduces the number of shares outstanding. Since there are fewer claims against the company's assets, each investor holds a greater proportion of the total shares. This is good news for the shareholders as it juices up the EPS.

There is another reason why stock buybacks are often so positively received. In essence, as mentioned earlier, the company is investing in itself. Now, a rational investor would only make an investment if they saw a large potential upside; that is, they believed the shares of the investment were undervalued. Thus, a share buyback has a signaling effect. Clearly, one would think that the management of a company would have better information about the prospects of a company compared to some analyst sitting in New York. It's only logical. The managers live and breathe the company, they know it inside and out. If they choose to pump money into its shares, logically, there should be some sort of reason for that. So investors recognize the information asymmetry and take this buyback as a cue to invest in the company.

In theory, this all sounds pretty dandy. However, there can be two flaws with this thinking, maybe you've already recognized them. First off, managers know about this signaling effect, and may try to fool investors into thinking their shares are undervalued. That is, they may make a sub-optimal investment in their companies' shares in order to reap the short-term benefits of a price boost. This short-term price boost could lead a sneaky manager to large profits, as he (or she) could then exercise his stock options. The problem with this is, in the long-run, investors will find out, and they will really punish the firm. The second flaw with the reasoning is that managers often have a biased, overly optimistic view of the firm's prospects. It's sort of a rah-rah-sis-boom-bah attitude that pervades the top management of many firms. The management's hubris is such that they feel that the market has really undervalued their shares, and that surely the prospects are much brighter than currently reflected in the share price. This can be dangerous, and actually does happen in real life, especially in smaller, family-run firms.

Another dubious reason for management issuing a stock buyback is to improve the financial ratios. For instance, a stock buyback reduces the number of outstanding shares. Fewer shares, same return, higher return on equity (ROE). A buyback also reduces cash. Fewer assets, same return, higher return on assets (ROA). ROA and ROE go up, everything is roses, right? Well, technically, yes. However, if this is the only reason why a company has initiated a buyback, then all those roses suddenly have a lot more thorns (yes, that was a veiled reference to Poison). Moving on, if you were paying attention earlier, you'd remember that I said that a buyback juices up your EPS, due to the fewer number of outstanding shares. This becomes important when considering the P/E ratio. Follow me here... fewer shares, higher EPS; higher EPS (ceteris
paribus), lower P/E. Many investors tend to think a lower P/E ratio is indicative of better 'value'. So the company is now cheaper, even though it has the same earnings.

There is another brief considerations regarding share buybacks. Many companies have buyback programs in place already, so why is there such a big hubbub when they announce more buybacks. These extra buybacks are usually above and beyond the baseline buybacks, which are in place to reduce the massive diluting effect of stock options. Each time someone exercises their options, the company mints some new shares. Thus, there is dilution. This dilution is usually eliminated through company buyback programs. Investors like this.

So, in summary, buybacks are pretty interesting things. They are generally viewed very favourably by investors for the reasons outlined above. When looking at a company in which to invest, take a look-see and find out if there is a share repurchase plan in place, or if there are rumours of one coming up. A company with lots of cash on the balance sheet, and not many strategic acquisition prospects on the table is a prime candidate for a share buyback, or a dividend*. So keep a look out for these companies, they could give a nice boost to your portfolio.

Note: Dividends are now taxed at an equal rate to share buybacks (capital gains tax). In 2003, President Bush signed a law which equalized the rate, leading to a huge boom in dividends, which were not as historically popular as buybacks.