Company Share Buybacks – always good?

Author: Steven posted in Investing basics tagged with Investing 101, Share buyback

When a company generates a large amount of free cash flow it can reinvest the money in the business, which can result in potential future higher profits, it can share the profits with the shareholders by paying dividends or it can buyback outstanding shares of common stock.

Company share buyback programs can be a plus for shareholders because they end up owning a bigger portion of the company and it is a tax­free transaction compared to dividend payments which are a taxable event for the receiver. Although in the surface share buybacks might seem to be a good decision from the perspective of the investor, you should analyze why the company is repurchasing the shares to make sure it is in the best interests of shareholders and not being done to “hide” something else.

If the share buyback is done for either of the two following reasons it might raise a red flag for the investor:

To hide a poor employee option plan

A company may decide to repurchase common stock to avoid increasing the number of outstanding shares due to excessive stock options they are providing to their employees. But by doing so, the company ends up selling the shares at a low price (an option is valuable only when the price is lower than the stock price) and then buying shares back at a higher price. This is not the best use of the owners capital.

To boost some of key financial ratios

The earnings per share (EPS) is one of the most important ratios because it is a measure of profit left for the shareholders. It is calculated by dividing the net income by the total number of outstanding shares. Even if the net income does not increase, by repurchasing shares, the company can boost this ratio. The net income of a company could be even going down from quarter to quarter but the EPS could be higher if the number of outstanding shares are reduced sufficiently due to the buyback. Another ratio that can be boosted by share buybacks is the P/E ratio which is the current share price divided by the annual EPS. The return on assets (ROA) which measures the ability of a company to turn assets into profits is boosted as well since assets will decrease due to the buyback. Last but not least, the return on equity (ROE) looks better because the share repurchase reduces the amount of owners equity.

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