The financial news media does it all of the time, don’t they? They assume that the millions of retail or part time investors know all of the terms used on a daily basis. When IBM announced another stock buyback, the financial news channels reported it leaving investors unsure of what that will mean for their IBM positions. Will the IBM stockholders make money or lose some?
What is a Stock Buyback?
Finally an investment term that actually means what it says. A stock buyback is sometimes referred to as a share repurchase but the terms mean the same. For reasons sometimes undisclosed, a company may elect to purchase some of their shares back from the investment community.
Why do they do it?
Investors only know what the company publishes in their press releases and SEC filings (like a 10-K) but there are two commonly accepted reasons to repurchase stock. First, the company believes that there is a valuation divide and the stock is under priced. Secondly, management cannot find a better investment for their free cash flow other than the company’s own stock.
As we all know, the stock market is an emotional place. While the business community likes to believe that all of their decisions are based on fact, that’s far from the truth. Take a look at the sometimes drastic moves that happen when a company misses earnings by no more than a penny. Remember when Apple missed earnings in October of 2010 and what was the technology bellwether just one day before became the reason that all of Wall Street sold off the next day? The market is far from purely objective.
Sometimes good companies have stock problems. A bad earnings report, a scandal surrounding a CEO or the company, or weakness in the broader market or their sector can make a good company have undervalued stock. When this happens, some companies take the opportunity to repurchase stock. Why let somebody else make money on their stock when they could do it themselves?
When a company repurchases stock because of improper valuation it is normally considered bullish for shareholders. This is the most common reason that companies buy back their stock and this is the reason that buybacks often trigger a sharp rise in share value.
There is another reason that isn’t as positive. Sometimes companies repurchase stock to make their numbers look better. The easiest place to see this is by examining the EPS or earnings per share number. The math for this metric is quite simple. You simply take the net income (minus dividends paid) and divide by the amount of outstanding shares.
If IBM has 30 million shares outstanding and they buy back 10 million, the EPS number suddenly goes up without the company having to make more money because the shares outstanding are reduced. Completely legal, but really this is just a bit of accounting and financial ratios trickery.
There are many other metrics where a stock buyback can make a company’s balance sheet look better but keep this in mind: If a company is buying back shares to make numbers look better, that’s not a good sign. As an investor, you should be asking yourself, “Why do they need to make their numbers look better?” Be wary of a company who does this.
How do they do it?
There are two ways that a company can repurchase shares. The first is a tender offer. Simply put, the company comes to you the shareholder and offers to purchase your shares of their company. Often, they will say to you, “we want to buy so many shares and we’re willing to pay this price range for them. What’s your price?” You then respond with the amount of shares you’re willing to sell and the lowest amount you’re willing to take for them.
This is bullish for investors because the company will almost always pay more than the current market price. You’re sure to make money on a tender offer.
The second way is by doing the same thing you do when you buy stock. They purchase it on the open market. They will still pay a premium for the stock because the mere announcement of a buyback will make the price of the stock go up.
So what’s the Bottom Line?
Chances are good that a stock buyback is going to be good for your portfolio. Some investors argue that once a buyback is announced, make your money and close out your position just in case there is something lurking that isn’t as bullish as once believed. But to answer our original question, if you owned IBM stock in October of 2010 when they announced an extension to their buyback plans; congratulations, you made some pretty decent money with the stock up nearly 25% since then!