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A company sells a product or a service, receives the money, pays off its operating expenses and debts, and whatever remains is the profit or ‘The Bottom Line’. Only three things are done at this stage: Money is reinvested in the company in the form of retained earnings, distributed to investors in the form of dividends or it is used to buy back outstanding shares. As dividend investors, it’s important for us to understand what all three funnels at the bottom of an income statement do.
Below dividend.com analyzes what a stock buyback is and how you should interpret it.
Companies essentially raise money through two sources: equity and debt. These two primary capital providers are paid back via dividends, which is called the cost of equity and interest, which is called the cost of debt. Whatever cash remains is re-invested in the company—but only if they find growth opportunities that can lead to a higher topline for the company going forward. If a company doesn’t find any growth opportunities, then it’s better if they buy out the outstanding shares and reduce their total cost of equity, which would lead to a lower total cost of capital.
Let’s assume company ABC Inc. has a profit of $1 million. They decide to re-invest 20% of the money ($200,000) and distribute 20% of the money as dividends ($200,000). They now have $600,000 left. They also have 1 million shares outstanding with each valued at $10, which brings them to a market cap of $10 million. If the company decides to buy back shares with the remaining $600,000, then they would be purchasing 60,000 shares, since every share is valued at $10. This would leave 940,000 shares outstanding. The company bought out 6% of its outstanding shares with this transaction.
EPS is defined as earnings per share. In the above case, the earnings of the company are $1 million. The number of shares outstanding are also 1 million. Therefore, the EPS is $1. With the buyback the company will have only 940,000 shares outstanding. This reduces the denominator of the equation by 6%. $1 million earnings divided by 960,000 would now give you an EPS of $1.04.
P/E, or price to earnings ratio, is the most popular measure to value companies in the stock market. It’s defined as price of the company divided by earnings per share. The P/E before the buyback was 10 ÷ 1 = 10. The P/E after the buyback would be 10 ÷ 1.04 = 9.61, thus, making the share undervalued.
Companies can buy back their shares if they feel that they are currently undervalued by the market and then they can re-issue them at a higher price when they feel that the shares are getting the valuation they deserve.
Companies usually employ a mix of dividend declaration and a buyback announcement at the same time. This strategy is influenced by the shareholder base of the company. If the shareholder base is primarily institutional looking for growth then the company is more likely to announce a buyback, while if the base is retail then the company is more likely to announce a dividend. Read more about how the shareholder base of a company affects corporate policies here.
Companies may artificially boost stock prices by announcing buybacks. Management compensation can also be linked to EPS of the company, and we saw above how the EPS can be boosted through buybacks. If the EPS can’t be grown organically by actually growing the business, then share buybacks can be an easy solution to the problem.
As mentioned above, buybacks are usually done by companies who don’t find growth opportunities in the market. It may be a sign that the market for the company has peaked out and it’s transitioning from a growth company to a well established market leader.
Some of the important buyback announcements taken place in 2016 that dividend.com covered can be found below: