You hear it on financial television or read it in the paper all the time: Company XYZ issues a huge stock buyback program. Conventional wisdom says buybacks are sign that the company itself thinks its stock is cheap. In theory, this would be the ultimate "inside information." The reality is quite different.
In this edition of Investing 101, Greg Milano, co-founder & CEO of Fortuna Advisors, a company specializing in shareholder value consulting, walks us through some of the basics on stock buybacks and sheds light on whether or not they're a reliable signal to buy shares alongside the company itself.
What's a Buyback?
Simply enough, Milano says a buyback is just the "act of a company taking some of its cash or some money it might borrow, and buying some of its own shares."
Significantly, an actual buyback versus one that's just announced, are different things. Often times a company will set a buyback policy of bidding for a stock under the current prices. It's a way for the board of directors to start buying its own shares when the stock price dips.
Why Would a Public Company Buy Its Own Shares?
It's not as silly a question as it may seem. Being public means selling a portion of the company to raise cash; usually for the purposes of cashing out insiders and investing in corporate opportunities. Selling shares to the public then buying them back sounds dangerously close to trading your own shares.
Milano says there are two basic reasons for buybacks. First, the company may not have anything better to do with its cash and they view this as having a better potential return than an investment in its own shares. In other words, the board of directors simply thinks a stock is too cheap.
The second reason is to increase earnings per share. Fewer shares mean EPS reports look more impressive than they really are.
Do Buybacks Lead to Higher Stock Prices?
Milano says yes in the short term. After that, not so much.
"Over time the companies that buy back more stock tend to produce worse shareholder returns,"he says. Earnings per share may have the appearance of growth, but Wall Street sees through the illusion.
"If you're growing EPS in a way that's really just financial engineering, the market doesn't think much of that," Milano states. Investors want real growth, not a shuffling of assets.
Add it up and buybacks are a lot of sizzle without much steak. They may give a short term pop to a stock, but once the excitement fades the shares tend to give back the gains, even with the company buying alongside regular investors.
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