Are Stock Buybacks Important?

| June 14, 2010 | 0 Comments

I was recently researching a company for another article.  As a matter of habit, I always take a look at the last few months of the company’s press releases.  You’d be surprised just how many people skip this step…

It’s like cooking an omelet for breakfast, but not putting the pan on the stove.

You’re skipping a vital step that can result in disaster.  Besides, you never know what you’ll discover.  While I was digging up my research, I came across an interesting press release… “Ormat Technologies Announces $50M Stock Buyback”.

To be honest, I skipped right over it.

Companies are always initiating stock buybacks.  It wasn’t something I wanted to dig into.  But then it dawned on me… stock buybacks could influence stock prices.

By using a stock buyback to purchase stock on the open market, the company is removing a source of supply, effectively reducing the number of shares outstanding.

Assuming demand for a company’s stock is fairly constant, the removal of supply should push the value of a stock higher.  It’s interesting in theory… and makes logical sense.  But, does it hold up in the real world?

Are stock buybacks important?

Before I give you my thoughts on the subject, let’s dig a little deeper.

Most investors would agree a manager’s top job is the allocation of capital.  It’s a fancy way of saying managers decide what to do with the business cash.  Some managers are better at it than others.

Take Warren Buffett for example.

He’s a stellar manager of company cash.  The billions of dollars of cash flow Berkshire Hathaway generates are wisely reinvested in other business opportunities.  Buffet’s been able to generate incredible returns of more than 20% annually for decades!

Other corporate managers aren’t quite as savvy.

Just look at the management team at Time Warner… when they bought AOL.  They spent billions buying AOL.  They ended up ejecting the company a few years later at a big loss.

While mergers and acquisitions are sexy… and new products are exciting… managers also have the option to send cash to shareholders.  This is the activity I like the best.

Often managers return cash to shareholders in the form of dividends.  I love getting paid to make an investment.  Most dividends are small, a few percent at most.  But every once in a while, you’ll find one that’s off the charts!

One investment I’ve made is paying out dividends over 27%!

Think about that for a moment… For every $100 I’ve invested, I get $27 back in dividends every year.  In the last 18 months, the stock has almost doubled in value and I’m still collecting my nice dividend.

While dividends are nice, some managers implement stock buyback programs.

Many would argue buybacks are better for investors than dividends.  If you receive a dividend, you need to pay taxes on it.  It reduces your overall return.

Stock buybacks work a little differently.

By purchasing stock on the open market, the company is effectively pushing the price higher.  By driving up the value of the freely traded stock, shareholders get the benefit of an increase in price.  And they can decide when to sell… if ever.

With a stock buyback, the price goes up (hopefully more than the dividend amount) and everyone is happy.  By controlling your exit, you’re able to better manage your tax liability… increasing overall returns.

There’s a big problem though.

In 2007 when the stock market was peaking, companies spent almost $600 billion on stock buybacks.  In late 2008 and 2009, you’d think companies would be grabbing shares at rock bottom prices.  Unfortunately, buybacks dropped to a pathetic $31 billion in the first quarter of 2009… when prices were the lowest.

Not many companies are able to step up and buy back shares at the right time.  Managers tend to buy when stock prices are high… not when they’re low.

As I dug deeper in my research, I realized something important.

Stock buybacks are just one arrow in the quiver for a good management team.  Standing alone, they don’t improve an investment.  However, used in conjunction with accelerated debt payments, dividends, and smart corporate growth strategies, stock buybacks can and do enhance company value.

While I’d never suggest buying a company solely because of a stock buyback, I’m always happy to see one in place.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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