“XYZ Company has announced a purchase of 2 million shares of their
own stock. The stock must be a good buy if the company itself is willing
to buy.”
It’s still a common belief. The stockbroker tells a client, the client
tells a friend, and so on, until a stock price begins to move upward. Many
of these and other investors who heard the good news rush out to purchase
more of the stock. The price continues to rise for the next few days and
weeks.
But is it really a good sign when a company announces a stock
buyback? Actually, company stock buybacks are often a mixed bag, with some good and some not so good effects. The Standard & Poor’s 500 stocks in Table 1 announced stock buybacks in 2002.
In his 1999 Berkshire Hathaway annual report, Warren Buffett had this to say about stock buybacks:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds—cash plus sensible borrowing capacity—beyond the near-term needs of the business, and, second, finds its intrinsic value, conservatively calculated.
WHY BUY THEIR OWN SHARES?
Companies have different motives for buying back their own shares. When employees exercise options, for example, earnings per share can quickly become diluted as the number of a company’s shares outstanding grows.
That worry prompted Yahoo’s move. Sometimes a buyback is a sign that a
company is very bullish about its own prospects. And with Nasdaq stocks
down, on average, over 40 percent since last summer, companies can buy a
lot more shares for fewer dollars, potentially giving a bigger boost to earn-
ings per share.
Obviously, stock buybacks create more value in the stock, thereby giving something to the shareholder: value instead of a taxable dividend. Another obvious point is the positive image a company puts out by announcing a stock buyback. They wouldn’t buy it if it were too expensive. Right?
GOOD NEWS AND BAD NEWS
Companies also use buybacks when they have bad news to report. Obviously, the well-timed positive announcements are intended to soften the blow. It’s the “we’ve got good news and bad news” situation. “We’re going to buy back 8 percent of our stock … and, oh, by the way, our earn-
ings are down 3 percent.” The company is hopeful that the good news will outweigh the bad, and therefore the price impact will be neutral to positive.
The good news/bad news technique is often used, even by some of the larger corporations. It can be quite effective.
As can be seen in Table 2, it’s not just small companies—mega-
corporations like 3M, MGM Mirage, and Beverly Enterprises are buying
back shares. The price of 3M Company rose to $85.25 a share by the end
of the year.
DOES IT SHOW CONFIDENCE?
Sometimes companies will boldly announce their buyback intention with the statement that the stock has investment value at the current price. But considering the price impact of all that good publicity, one wonders. Is the announcement just more window dressing, or is the company sincere?
Short-term speculators have a great time with stock buyback announcements. To have a price rise several percentage points in just a few days is one of their dream selections. In fact, this is good for the spec-
ulators in the short term but not necessarily helpful to investors in the long term. So what’s the problem? Are companies dumb enough to pay prices that are actually too high? Peter Russ seems to think so. The following comments on stock buybacks are from U.S. News & World Report:
The hitch. What could be wrong with this picture?
Simply this: Many companies’ shares are selling at or near record prices and may not be worth buying by anyone.
Many analysts calculate a company’s intrinsic value based on business potential rather than on the actions of excited buyers. When companies buy
their own shares at or below the “intrinsic value,” they effectively create added value for the other shareholders. When they buy significantly higher than intrinsic value, they push the price up temporarily, but the value has to catch up in support. Paying that high price can cause problems.
“But the minute that you start paying a premium to buy back your stock,” says Russ, “you are probably destroying value—using company money in a way that’s not going to earn a great rate of return.”2
SHOULD WE BE WARY TODAY?
It’s always good to be wary about the stock market. Historically, compa-
nies with too much money would either expand or return some money to
shareholders in the form of dividends. The problem with dividends is that
they are taxed. In fact, they are taxed twice, first as corporate income and
second as investor dividends. Therefore, dividends aren’t as popular as
they once were.
Companies still like to show growth. They like to announce the opening of 200 additional retail outlets or the opening of a new plant to employ 2,000 workers. It’s the kind of publicity that creates a warm feeling in the company’s investors and customers. But what does it mean when the company is not expanding and is buying back its own shares? Don’t they have anything better to do with the money? Have they run out of ideas? If they really think the company is undervalued, shouldn’t they be investing the money in preparation for the new growth? These are real concerns the long-term shareholder and potential stock buyer should have.
Stock buybacks don’t necessarily add significant value to a company’s stock. The P/E ratios are too high and companies have too much cash, the cash being the reason they’re willing to overpay. There’s less risk in buying back their own shares than in new corporate growth, or at least less risk in how the actions are perceived by investors.
ONLY AN ANNOUNCEMENT
Some stock buyback announcements are just that—announcements. Following the announcement, either the buyback never occurs or fewer shares are repurchased. Possibly the company originally intended to repurchase the shares, but things change and they are later unable to do so because the economics have changed. The financing became unavailable.
Although companies are occasionally accused of trumpeting a stock buyback for the purpose of supporting or accelerating the price, in reality that practice is unusual. The large majority of stock buyback activities are sincere.
WHAT HAPPENS TO THE STOCK?
Much of the stock is effectively retired, clearing up some of the dilution problems. Other shares are used for employee retirement and stock option plans. Obviously, this is a good effect if the shares have true value, but a negative effect if they are overpriced.
Stock buyback announcements have many implications. In some cases it is a positive move for the company and its shareholders, even if only temporary. It improves the earnings per share since there are often fewer shares outstanding. And a stock price will often rise after a buyback announcement, especially in a rising market. However, the price can weaken and fall if negative news follows. An understanding of the company’s announcement and the current true value of the stock can help an investor decide whether to buy or sell the stock.
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