Share Buyback Programs Are Not As Great As Investors May Think

by Hank Coleman

Wall Street sign in New York CityNow that the economy is slowly recovering, investors will see share buyback programs coming back into vogue once again with companies and investors. When a company has excess cash on its balance sheet, the company’s management must make hard decisions on what to do with that surplus cash. Lately, a stock buyback program which are also known as share repurchase programs have been a popular option especially in a down market when share prices have been beaten up. A share buyback program is when a company purchases outstanding shares from current shareholders on the open stock market. There are both good and bad facets to this monetary move.

The Positive Aspects….

Reduction Of The P/E Ratio And Shares Outstanding

When a company buys its shares back, they then retire them and thereby reduce the total number of shares that are outstanding. So, shareholders who do not sell their shares back to the company inevitably own a greater percentage of the company with each share that they own. With less shares floating out in the marketplace, the company immediately enjoys a reduction in their stock’s price to earnings ratio (P/E Ratio). The ratio is calculated as share price over the amount of earnings the company enjoyed on a per share bases. With less shares available thanks to a repurchase program, the company’s profits are divided among fewer shares increasing the denominator of the P/E Ratio equation therefore reducing the P/E Ratio. A smaller P/E Ratio implies a company that is traded at a share price lower than its intrinsic value and that of its peers as well. Reducing the number of common shares in the marketplace is a quick way to show Wall Street that your company’s stock price should be worth more than it current is. Share buybacks also reduce the amount of assets on the balance sheet. Therefore, key metrics such as return on assets (ROA) increases because assets are reduced, return on equity (ROE) increases because there is less outstanding shares or equity. In general, the stock market and investors view higher ROA and ROE ratios as positive aspects.

The Negative Aspects….

Share Buybacks Are A Sign Of Lack Of Creativity

But, share buybacks are not all roses and pots of gold for investors. When a company buys back shares of its stock, the company is indirectly signaling to a degree to investors that it does not have anything better to do with its available cash. Companies buy back its own shares of stock when there are no other shares of smaller companies to acquire. There may be no other profitable opportunities to grow the business, and that is why the cash as been piling up. Many investors would much rather see companies spend its money on buying smaller companies, increasing research and development, or expanding its reach through new areas, stores, and territories.

Companies Do Not Have To Abide By Buyback Announcements

When companies announce that they are going to buy back shares of their stock, they are making a statement in the forum of public opinion. It is not a binding agreement. There is no obligation for companies to keep their promises to buy back their stock if things change in the marketplace and economy. Many companies will announce large grandiose buyback proposals and only complete a fraction of them before abandoning the buyback altogether. The companies can stop buying shares at any time.

One way to look better on paper and spend excess cash on the balance sheet is for a company to buy back its shares on the open stock market and return them to the company’s treasury never to be seen or heard from again. So, as an investor, take the announcement of a company’s share buyback plan with a grain of salt. Share buyback programs may not be as great an event as investors immediately think. Reducing the number of shares of stock being traded is a quick way to change some of the most critical ratios that Wall Street uses to evaluate a company’s stock price and future value.

(photo credit: Shutterstock)

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