How Share Repurchase Programs Affect Stock Prices

Exactrades July 3, 2012 0
How Share Repurchase Programs Affect Stock Prices

There are several ways a company can return wealth to its shareholders. Dividends and stock price appreciations are the two most common ways of doing so. However, there are other useful and usually overlooked ways for companies to share their wealth with investors. Therefore the objective of writing this piece is to acquaint you with one of those overlooked methods: shares repurchase and how the program affects the stock prices.

WHAT IS A STOCK BUYBACK PROGRAM?

Share repurchase, aka. Stock buyback, may be defined as a program by which a company buys back its own shares from the marketplace, and in the process reducing the number of outstanding shares. The company reacquires by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity. The repurchases shares are either retired or kept as treasury stock, available for re-issuance.

Share repurchase is usually an indication that the company’s management thinks the shares are undervalued. For that reason, during bear markets there will often be an increase in the number of companies announcing a stock buyback. Though disregarded many times, the potential value of repurchase announcements per se could be substantial information from the trading or investing viewpoint.

HOW IT CAN AFFECT STOCK PRICES

Of course these programs are aimed at keeping the investors happy. So in order to understand its effects on stock prices, it would be essential to discuss its relevant benefits and pitfalls. The most notable benefit of a repurchase program is that it increases shareholder’s value. There are several ways to calculate the profitability of a company, however, one of the most common is Earnings Per Share (EPS). So even with the same amount of earnings, but reduced number of outstanding shares, an increase in EPS will result. An increased EPS usually alerts the investors that the stock is undervalued, therefore can accompany an increase in stock prices. So yes, a share repurchase program will mostly have a positive effect on the stock and drive the prices higher. However to confirm this, analysts and investors usually study firm’s motive behind the repurchase programs. A firm’s management is likely to tell you that a buyback is the best use of capital at a particular time. While this could be the case most of the time, it is not always true. A quick look into a company’s financial ratios and debt owed can give insight into a management’s motives. Ideally, a repurchase program should be employed if the company has excess cash on hand, want to reduce taxes or to support the price of their stock in extreme bear markets.

On the other hand, there are ways shares repurchase can bring down the stock’s price. The motive behind the company’s action should always be questioned and whether or not it is supported by the financial data. Incoherence can usually lead to a negative influence on the stock’s price. Some common reasons for this could be manipulation of earnings or an unfavorable buyback percentage. Manipulation of earnings occur when a company buys back its shares so as to appear to beat consensus estimates that were based on a larger number of outstanding shares. The percentage of shares bought back typically drives the stock’s price. It is generally believed that the higher the buyback percentage the greater the potential of profits, but companies typically do not divulge details of buyback percentages in their announcements. An investor should assess a company’s financial data before placing any trades. In addition to these, non-execution of announced buybacks or buybacks when the stock prices are high are other reasons for price declines.

SUMMARY ON REPURCHASE PROGRAMS

Though a shares repurchase program is usually considered as a positive development leading to higher stock prices, in some cases it can also bring down a stock’s price. These programs take advantage of supply and demand by reducing the number of shares outstanding, increasing EPS shareholder value and eventually the price of the stock. However, not all shares repurchase programs are actually implemented so proper research is advisable.

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