When a company announces a stock buyback, sometimes known as a share repurchase, is this a good or bad sign for investors? Well, it depends.
When a company has excess cash to work with, it has several options. It can set aside some of it for emergencies, improve its infrastructure, reduce debt, acquire other companies, issue a dividend, or buy back some of its shares on the open market.
If the rise in the company’s cash balance is only temporary, then it’s preferable to pass that money on to shareholders through a share buyback program rather than committing to an increased dividend stream that might be tough to sustain.
A buyback sends a signal to investors that management not only has enough money saved for a rainy day, but also feels positive on its future prospects and that of its industry.
A Vote Of Confidence
Just this week for instance, Canadian National Railway, the biggest railroad operator in the country, announced both a two-for-one stock split as well as plans to buy back up to four per cent of its shares in the open market.
This suggests that management still believes the stock price to be somewhat undervalued – an outlook many observers seem to agree with. These shareholder-friendly moves and strong third-quarter results gave the stock a nice boost, prompting several analysts to raise their price targets accordingly.
Practically speaking, share buyback programs take advantage of supply and demand by reducing the number of shares outstanding, increasing shareholder value, and sometimes the price of stock. Each share subsequently becomes more valuable because it now represents a greater percentage of ownership in the company.
Buybacks May Signal Bargains
When a company introduces a share buyback, it’s essentially saying that its shares are a good bargain at this price. Or that it feel the opportunities currently available simply aren’t attractive enough for it to part with the money on hand. This can be a red flag for “growth” investors, however, since they’re looking for continued expansion in both the company’s revenue and profit.
When a rapidly growing company chooses to spend its cash on its own shares rather than reinvesting it internally or wolfing down the competition, it’s essentially saying that there aren’t as many profitable opportunities to grow the business as there have been in the past.
Too Much Cash On Hand
That’s one of the reasons that Carl Icahn, the billionaire activist investor who has made a career of urging companies to adopt changes to boost shareholder value, has been lobbying Apple for a $150-billion share buyback. With the stock still down sharply from its highs, Icahn argues that the company doesn’t need nearly that much money on hand and should return a pile of it to shareholders.
There are sometimes other factors at work when it comes to buybacks, some of which have more to with window dressing. When a company buys back its shares, it gives its ratios a temporary boost, for instance. Since share buybacks reduce the number of shares outstanding, ratios tied to this figure, such as earnings per share and price-to-earnings, improve. Reduce the number of shares and even though earnings don’t change, the EPS looks better.
Another motive behind a buyback may have to do with large employee stock option programs. When employees exercise their stock options, the number of shares outstanding actually increases, correspondingly reducing each current shareholder’s ownership. Share buybacks can help offset this dilution.
One caveat when it comes to buybacks: There’s no obligation for companies to honour their promises to buy back their stock. If the economic picture changes or the company hits a rough patch, it can stop buying shares any time it likes.