Investors should also proceed carefully if the buyback appears motivated by management's desire to improve its valuation metrics or put another way, to manipulate them. A company that uses buybacks to create the appearance of quick growth in earnings per share, for instance, may not be a company worth owning. As with many things in investing, the answer isn't clear-cut.
If the company genuinely has cash to spare, and its shares are arguably undervalued, then a buyback can be a good way to generate benefits for shareholders. But if its shares are expensive, it's worth asking why the company isn't choosing to pay a special dividend to its shareholders instead -- or hanging on to the cash for a rainy day. Discounted offers are only available to new members.
Stock Advisor will renew at the then current list price. Investing Best Accounts. Stock Market Basics. Stock Market. Industries to Invest In. Getting Started. Planning for Retirement. Retired: What Now? Personal Finance. Credit Cards. About Us. Who Is the Motley Fool? Fool Podcasts. In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price. Another major motive for businesses to do buybacks: They genuinely feel their shares are undervalued.
Undervaluation occurs for a number of reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items or a general bearish sentiment. A wave of stock buybacks swept the United States in and when the economy was undergoing a nascent recovery from the Great Recession.
These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities. If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re- issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share EPS ratio is automatically increased — because its annual earnings are now divided by a lower number of outstanding shares. Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback.
The return on equity ROE ratio is another important financial metric that receives an automatic boost. One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding.
It can also be viewed by the market that management has enough confidence in the company to reinvest in itself.
Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock. A stock buyback affects a company's credit rating if it has to borrow money to repurchase the shares.
Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves , which are frequently needed when economic winds shift against a company. For this reason, credit reporting agencies view such-financed stock buybacks in a negative light: They do not see boosting EPS or capitalizing on undervalued shares as a good justification for taking on debt.
A downgrade in credit rating often follows such a maneuver. Despite the above, buybacks can be good for a company's economics. How about the economy as a whole? Stock buybacks can have a mildly positive effect on the economy overall. They tend to have a much more direct and positive effect on the financial economy, as they lead to rising stock prices. But in many ways, the financial economy feeds into the real economy and vice versa. Research has shown that increases in the stock market have an ameliorative effect on consumer confidence, consumption and major purchases, a phenomenon dubbed "the wealth effect.
Another way improvements in the financial economy impact the real economy is through lower borrowing costs for corporations. In turn, these corporations are more likely to expand operations or spend on research and development. These activities lead to increased hiring and income. For individuals, improvements in the household balance sheet enhance chances they leverage up to borrow to buy a house or start a business.
Securities and Exchange Commission. PR Newswire. Board of Governors of the Federal Reserve System. The philosophy had immediate appeal to the raiders, who used it to give their depredations a fig leaf of legitimacy.
And though the raiders were eventually turned back, the idea of shareholder value proved harder to dispel. If their conversion to the enemy faith was at first grudging, CEOs soon found a reason to love it.
To accomplish this goal, boards began granting CEOs large blocks of company stock and stock options. The shift in compensation was intended to encourage CEOs to maximize returns for shareholders. In practice, something else happened. The rise of stock incentives coincided with a loosening of SEC rules governing stock buybacks.
It relented just before CEOs began acquiring ever greater portfolios of their own corporate stock, making such manipulation that much more tantalizing. Too tantalizing for CEOs to resist. Today, the abuse of stock buybacks is so widespread that naming abusers is a bit like singling out snowflakes for ruining the driveway.
But somebody needs to be called out. But buybacks are more than just unfair. The pharmaceutical company was a paragon of corporate excellence through the second half of the 20th century. How is this sustainable?
Merck insists it must keep drug prices high to fund new research. Finally, consider the executives at Applied Materials, a maker of semiconductor-manufacturing equipment. As is the case at many companies, its CEO receives incentive pay based on certain metrics. One is earnings per share, or EPS, a widely used barometer of corporate performance.
Normally, EPS is lifted by improving earnings. But EPS can be easily manipulated through a stock buyback, which simply reduces the denominator—the number of outstanding shares.
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