With earnings season set to ramp up in the coming weeks, an interesting theme to keep in mind during this period is corporate buybacks.
A buyback occurs when a company repurchases its outstanding shares to reduce the number available in the market. Companies often conduct buybacks to increase the value of their underlying shares by effectively decreasing supply. Organizations also do this to increase their stake in an attempt to ward off unwanted takeover overtures.
It's important to note that buybacks can also trigger other positive developments for companies that execute them.
For example, by reducing the available shares, a company can synthetically boost its earnings per share (EPS). EPS is calculated by taking a company's total earnings and dividing them by the number of outstanding shares.
By buying back shares, a company has therefore reduced the denominator of that equation - which means that all else being equal, they have also inadvertently boosted the resulting EPS.
Bob Pisani noted in an article for CNBC.com entitled "Why Apple is Joining the Ranks of the Buyback Monsters," that Apple's buyback activities have this exact effect, whether intended or not.
Pisani said of the practice, "One shining example is Apple, which has reduced its share count by 4.7 percent year-over-year, and 10.3 percent in the last two years, meaning earnings are 10 percent higher than two years ago, regardless of whether sales were higher or costs were lower!"
If that doesn't open your eyes a bit, consider that Pisani also referenced some Standard & Poor's statistic indicating that "Twenty percent of S&P 500 companies have reduced their share count by at least 4 percent year over year in each of the last five quarters, and that appears to be continuing into the second quarter [of 2015]."
Considering the above information, it's maybe not so surprising that such a large percentage of companies execute this corporate maneuver.
Unfortunately, there are also some negatives that shareholders should consider with regards to corporate buybacks.
Deploying a buyback program requires extra cash, which means that the underlying stock being bought is likely not cheap. Companies that have extra cash are generally doing well and have high stock prices, which means the organization is paying a premium to remove a portion of their stock from the market.
When economic conditions deteriorate, and a company's shares fall in the market, the prices being paid during a buyback may seem in hindsight like a foolish investment. An expert from this field interviewed by the The Wall Street Journal estimated that the poor timing of many buybacks results in, "acquirers overpay[ing] and thereby destroy[ing] long-term shareholder value about two-thirds of the time."
A past episode of You’ve Gotta Be Kidding Me on the tastytrade financial network reveals more details on the intricacies of stock buybacks.
Using Oracle (ORCL) as an example, hosts Tom Sosnoff and Tony Battista present research showing Oracle’s earnings before and after their corporate buyback.
This information is illustrated in the graphic below:
The hosts go on to discuss the possibility that buybacks may also mask larger problems for a company - not only in terms of making the earnings more difficult to interpret.
Imagine a firm's management team electing to buy back stock instead of expanding their own operations. What does this say about the current business environment or that team's creative approach?
Coupling those questions with the fact that buybacks tend to occur when stock prices are high means shareholders should probably be relatively warier when such activity is announced, as opposed to less.
We hope you will take the time to review the entire episode of You’ve Gotta Be Kidding Me focusing on corporate buybacks when your schedule allows.
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.