Despite the lofty level of the overall stock market and pricey valuations for stocks, many companies are undertaking very large share buybacks, making them attractive candidates for additions to portfolios. Stock repurchase plans, more commonly referred to as stock buybacks, involve the company using cash on their balance sheet to purchase their own shares in the open market. Although this action reduces cash balances, it can have a very powerful, positive impact on the share price of the company’s stock. By purchasing shares, the company creates what is known as treasury stock, with these shares typically held on the company’s balance sheet never to be reissued. By buying their own shares, the company positively impacts the share price in three ways:
1. Just by announcing a share buyback, the company typically sees a significant bump up in the share price, as investors respond to the announcement.
2. The purchases themselves drive the price up, all other things being equal, due to the added buying pressure. This is especially powerful if the company is buying a large number of shares over a relatively short time-frame.
3. By reducing the number of shares outstanding, the earnings of the company are spread over a smaller number of shares, thereby increase the earnings per share for the company. This makes the company’s stock more attractive, or more undervalued compared to the valuation before the share repurchases. Here’s an example:
200 shares outstanding prior to share repurchase with $100 in earnings; earnings per share are: $100/200 = $0.50 per share
100 shares outstanding after 100 shares are repurchased by the company; earnings per share are: $100/100 = $1.00 per share
If the share price is $10, the price/earnings (P/E) ratio would be 20X before the buyback and only 10X after the buyback. Investors would view the 10X multiple as being much more attractive (undervalued) as compared with the 20X multiple, and therefore would be more likely to buy the stock, thus driving the price up.
Some of the most notable share buybacks of 2014 include Apple, which announced that a $30 billion share repurchase last year (The buybacks were part of a larger $130 billion capital return program that the company said would extend through 2015); Wells Fargo, which, as part of its 2014 capital plan, said it would increase its buybacks by 350 million shares, or a total of almost $17 billion (It also boosted its dividend rate by about 17% to $0.35 a share); 3M authorized a $12 billion stock repurchase program in February of last year, replacing its then-current $7.5 billion buyback program (3M’s move followed its announcement that it intended to spend $10 billion on acquisitions and repurchase up to $22 billion of shares over the coming four years).
There are many other examples, but suffice is to say that share buybacks, especially very large ones, can be incredibly positive for a company’s share price. They are also a good indicator of management’s focus on returning excess cash, at least indirectly, to shareholders. Companies that consistently repurchase shares tend to perform quite well in comparison to those that do not repurchase shares.