Is a stock buyback scheme a good sign?

Hi there,

Stock buy back offers or stock repurchase offers are generally understood to be a good sign. This is one indirect way for cash rich companies to maximise the wealth of its shareholders.

LET’S TAKE A CLOSER LOOK

The idea behind share buy back is simple. The company uses its cash to repurchase it’s shares from the open market. Since the company cannot act as its own shareholder, the repurchases shares are absorbed by the company and the number of shares outstanding is reduced thereby increasing the EPS. So buy backs result in increase in shareholders value.

Another reason why a company would resort to share buy backs is to improve its financial ratios – For example, buybacks reduce the cash component on the balance sheet. Since cash is an asset, it effectively reduces the total assets of the company. Since ROA is calculated as return / total assets, any reduction in the total assets figure will improve the ROA figure. Similarly, re purchase results in a reduction in the number of shares outstanding. Since ROE is calculated as return / number of shares, any reduction in the number of shares will improve the ROE figure. So, if the company is buying back its shares with the sole intention of improving its rations like ROE and ROA, that’s not a good sign.

Another problem stock buybacks seek to cure is the dilution (too much stock on the open market) caused by stock option plans. When stock options are exercised the number of outstanding shares increase. This makes the company’s ratios look weaker – the opposite of what repurchasing does.

The buyback offers however, reduces the book value of the company. ( see the example below)


Advantages to the Investor

  • Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great!
  • Improving EPS also means that the P/E of the company is reduced. A lower P/E, higher EPS, ROA and ROE are regarded as positive signals by investors.
  • Buying back stock uses up excess cash which otherwise remain idle.  Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.

Example:

Lets take the financial figures of company xy ltd-

Before buyback

  • The total assets of the company are 5000 lakhs and the total liabilities are 3000 lakhs. Hence, book value would be (assets – liabilities) = 2000 lakhs.
  • Assuming that the company has 1o lakh shares outstanding, the book value per share would be (2000/10) = 200 per share.
  • If the earnings of the company for the year was Rs 250  lakhs, the EPS of the company would be 25 ( 250 /10)
  • ROE would be 25/200 = 12.50 %

Let us assume that the shares of the company are trading at Rs 250 now and the company proposes to buy back 25% of its shares from the market.

Post Buy back

  • The company would need 625 lakhs to buy 25% shares @ Rs 250
  • The company takes cash worth 625 lakhs and buys back the shares.The assets of the company now get reduced by Rs 625 to Rs 4375 lakhs.
  • The number of shares outstanding is reduced by 2.5 lakh shares to 7.5 lakhs
  • New book value would be Rs 1375 lakhs (Rs 4375 lakhs – 3000 lakhs  ) therefore, book value per share = 183.33 per share
  • EPS = improved from 25 to  33.33 (250 / 7.5)
  • ROE increased from 12.50% to 18 % ( 33.33 / 183.33)

As you can see, figures like price earnings ratio, earnings per share, return on assets, return on equity and others can be pumped up by a stock buyback program. So even if nothing has fundamentally changed about the company, the ratios will give a better picture after buyback. . All weaknesses in the business model before the stock buyback will still be there after the buyback.

CONCLUSION

Stock buy backs may not be a positive sign always.Do not buy a stock as soon as a stock buy back is announced, expecting a rise in prices. Always look behind the scenes and find out the real picture behind the buy back.

You may like these posts:

  1. Bonus shares – A positive sign.
  2. Understanding price to book ratio
  3. Stocks-explained

4 Responses to “Is a stock buyback scheme a good sign?”

Murali Krishna

April 7, 2011 at 7:36 pm

Dear Jins Victor,

I happened to visit your site while trying to get some information on shares since I am new to this side of the world. Your site is very informative and all your articles are very lucid, clear and easy to understand. Thank you.

Oflate, I have observed some IPOs, Like Lovable lingery, Shilpa cables, PTC finance. While CARE, CRISIL gave better ratings to PTC India Finance indicating fundamentals are good, but at the hustings, it faltered and even today, it was much below its IPO price. While Lovable and Shilpa were given not so good ratings are going gung ho. May be this is for a short term. I would like you to throw some light on the IPOs, and especially for this kind of market reaction.

J Victor

April 8, 2011 at 4:51 pm

Thanks for the suggestion. IPOs will be dealt in a separate session.

Melissa

September 20, 2011 at 10:08 pm

I wish I would have had that ifrnomatoin earlier!

Anonymous

October 8, 2011 at 3:17 pm

Nice. Bookmarked To Check Bit Later.

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