How a Share Buyback Can Build and Shape Great Companies
Posted by Reggie James | Filed under Business Strategy
Most shareholder and investors have heard of corporations authorizing share buyback programs. So, what are they and how do they work? What are the benefits to the company as well as the shareholders, traders and investors in that company?
What I’d like to do is take 5 minutes of your valuable time and share, educate and inform you on the importance and significance of a company share buyback and why with the buy-in of investors, it can help build and shape great, admired companies.
So what is a share buyback?
Well, the simplest definition is in Wikipedia: A share Buyback (or Stock repurchase) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.
Who does share Buybacks?
Many companies. In the last few days there have been numerous share Buybacks, here are a few:
Bank of New York Mellon Corp. (BK)
Limited Brands Inc. (LTD)
VanceInfo Technologies Inc
The 2 major principals of a Share Buyback
Joshua Kennon who writes for About.com and as well as other respected financial publications puts it simply and I’d like to quote him direct along with his excellent example:
Is overall growth as important as growth per share?
Too often, you’ll hear leading financial publications and broadcast 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. Growth per share is.
An over-simplified example may help. Let’s look at a fictional company:
Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
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Market Capitalization: $5,000,000
This year, the company made a profit of $1 million dollars.
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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 goes and 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. This 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! This 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, it is possible that someday there may only be five shares of the company, each worth one million dollars. 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 the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 in recent months. That is long term value!
So, if we combine the 2 principles highlighted above the share buyback is a positive confirmation of a company’s maturity and self-belief. In a tentative and sometimes fragile market, this can only be a good thing.
References & Sources: Thanks to Joshua Kennon and Bloomberg & WSJ
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