The Benefits of Stock Buyback Programs

The Golden Egg of Shareholder Value

Close up of stock certificate
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Occasionally, a company will choose to buy back shares of its stock. This is called a buyback, or share repurchase program.

It is nothing new and should come as no surprise even to the most novice investors. Like dividend programs, these events are so common that, even if you don't know what they are or how they work, you are at least likely to understand why, in most situations, they are a good thing.

It is also important to know that in some cases, as I explained in Understanding Stock Repurchase Plans, there are some potential dangers of share buyback programs. Here are three important truths to remember about these programs, and most importantly, how they make your portfolio grow.

Growth per Share Is Key

Too often, you'll hear leading financial publications and broadcasts talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow.

An over-simplified example may help. Take this fictional company:

Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
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Market Capitalization: $5,000,000 ($50 per share X 100,000 shares outstanding)

This year, the company made a profit of $1 million dollars.
In this example, each share equals .001 percent of ownership in the company. (100 percent divided by 100,000 shares.)

Management is upset by the company's performance because it sold the exact same amount of candy this year as it did last year. That means the growth rate is zero. The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree; the company will use the $1 million profit it made this year to buy stock in itself.

So the very next day, the CEO takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. (Remember it is trading at $50 a share according to the information above.) Immediately, he takes the shares to the Board of Directors, and they vote to destroy them so that they no longer exist. It means that now there are only 80,000 shares of Eggshell Candies in existence instead of the original 100,000.

What does that mean to you? Each share you own no longer represents .001 percent of the company. Instead, it represents .00125 percent; that's a 25 percent ncrease in value per share! The next day you wake up and find out that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the company didn't grow this year, you still made a twenty-five percent increase in your investment. 

Your Equity Share Increases

When a company reduces the number of shares outstanding by declaring a stock buyback program, each of your shares becomes more valuable and represents a greater percentage of equity in the company.

If shareholder-friendly management such as this one is kept in place for many years or decades, it is possible that someday there may only be five shares of the company left outstanding, each worth $1,000,000. When putting together your portfolio, you should seek out businesses that engage in these sorts of pro-shareholder practices and hold on to them as long as their fundamentals remain sound.

A Potential Pitfall

Stock buyback programs are not good if the company pays too much for its own stock. Even though buybacks can be huge sources of long-term profit for investors, they are harmful if a company pays more for its stock than it is worth. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself.

Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market swung the other way and is trading below its true value, shares of the company can be bought back at a discount, ensuring current shareholders receive maximum benefit. Remember, even the best investment in the world isn't a good investment if you pay too much for it.

Possible Public Relations Backlash

Share buybacks are not always met with rousing applause. While they can make investors happy, there is always a risk that the public (and some investors) will question why profits are being spent to boost shareholder value instead of investing bacj into the company or paying workers more money. Thus, some companies will choose not to buy back shares simply to avoid bad publicity.