Trillionaire Term of the Day - March 24, 2009 - Stock Buybacks

Stock Buybacks

Stock buybacks, which are also called share repurchases, occur when a company buys back its own shares from the marketplace.  This action by the company reduces the number of outstanding shares that the public is able to buy and sell. 

So, how do stock buybacks benefit investors? Because stock prices are determined by multiplying the P/E ratio by the Earnings per share (EPS), then it would make sense that a higher EPS would lead to a higher stock price.  EPS is calculated by dividing a company’s net income by the number of outstanding shares. So, when a company repurchases its shares, it is decreasing the number of outstanding shares.  This action decreases the denominator in the EPS formula, thus increasing the company’s EPS.   Because the EPS increases, the overall stock price for the company also increases. 

Let’s do an example.  If Company A has a P/E ratio of 10 and an EPS of 2, the company’s stock price will be $20.  Let’s also assume the company has a net income of $200 and has 100 shares outstanding, thus explaining the EPS of 2 ($200 NI / 100 shares).  If Company A decides to repurchase 50 shares, it will only have 50 shares outstanding.  So, the new EPS will be 4 ($200 NI / 50 shares).  So, if the P/E ratio remains at 10 and the EPS has increased to 4, then the new stock price will be $40 (P/E ratio 10 * EPS 4).  When Company A repurchases half of the outstanding shares, the company’s share price doubles!

It should be clear by now that share repurchases are great for investors.  But, why do companies repurchase shares, and what kind of companies repurchase shares?  Companies with a lot of excess cash are more likely to repurchase shares, mainly because they have the money to buy back their shares.  For cash-rich companies, the best way to directly reward investors is through dividend payouts or through stock buybacks. 

Most of the time, companies that repurchase shares do it because they believe their stock price is undervalued.  By buying their own shares at the perceived discounted prices, companies believe that they will be able to greatly profit in the long run when the stocks that they have purchased appreciate in price. 

Make sure to stay on the lookout for companies that have already repurchased shares or are potential candidates to do it.  When a company buys back shares, it shows that it has a lot of excess cash, but it also shows that the company thinks its stock price is undervalued and that it will go up in the future.  Stock buybacks are a very solid indication of what the company thinks about its own future, as a company would not repurchase shares if it thought that its share prices were on the way down.

Niki Pezeshki

College Trillionaire