The Benefits of Stock Buyback Programs
The Golden Egg of Shareholder Value
Corporations authorize share buyback programs, also known as repurchase programs. 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.
For those of you who don't know what stock buyback programs are, or if you who need a refresher course on the benefits of stock buyback programs, here are three important truths to remember about these programs, and most importantly, how they make your portfolio grow.
Principle 1: Overall growth is not nearly as important as growth per share.
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. Let's look at a fictional company:
Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
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% of ownership in the company. (100% 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 0%! 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% of the company. Instead, it represents .00125%; that's a 25% increase 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 on your investment! It leads to the second principle.
Principle 2: When a company reduces the amount 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 a 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. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. After it began buying back its own stock, it once traded as high as $650 within months of when I originally penned this article in 2003. That is long-term value!
Principle 3: 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.