Personal Finance 101

Written by Tyler |

When a company buys back its own stock, there are many advantages to the investor. However, there is a major advantage of stock buybacks to the company managers that we don’t normally hear about.

First, let’s talk about why we like stock buybacks.

Advantages to the Investor

1. 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!
2. Buying back stock uses up excess cash. The returns on excess cash in money market accounts can drag down overall company performance. Cash rich companies are also very attractive takeover targets. Buying back stock allows the company to earn a better return on excess cash and keep itself from becoming a takeover target.
3. 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.
4. Buying back stock can increase the return on equity (ROE). This effect is greater the more undervalued the shares are when they are repurchased. If shares are undervalued, this may be the most profitable course of action for the company.
5. When a company purchases its own stock it is essentially telling the market that they think that the company’s stock is undervalued. This can have a psychological effect on the market.
6. Stock buybacks also raise the demand for the stock on the open market. This point is rather self explanatory as the company is competing against other investors to purchase shares of its own stock.

What Management Doesn’t Want You To Know!

There are several reasons why management would prefer to buy back stock rather than raise the dividend.

The first reason is that upper management typically will receive compensation that is tied to the company stock price. What this means is that they typically make more money when the stock price goes up. This compensation may come in the form of stock options, rights or other forms.

In the short term management believes that dividends may work against the stock price of a company by reducing the book value of the stock. In addition, if managers have stock options, they do not immediately benefit from dividends as their options do not qualify for dividend payments.

On the other hand, when a stock buyback occurs the short term implications on the stock price are typically positive (due to the previous listed reasons). And, since this allows management to see the most immediate results to their compensation, it is no wonder that managers prefer stock buybacks as opposed to dividend increases.

What to Watch For

As an average investor, it is beneficial to us to look for companies that have both the cash-flow to buy back shares as well as regularly increase their dividends. One specific thing to look for is the dividend payout ratio.  Companies that have a lower dividend payout ratio, say below 60% of earnings, will have more money to invest back into the company and grow the stock price.  These can be some of the best long term investments because the company finds multiple ways to increase shareholder value.