As an investor, you may have heard the phrase stock buybacks get thrown around every once in a while. Some of the companies that you own in your portfolio may have participated in stock buybacks a time or two. The point of the matter is for you to understand what this means for you as the investor.
A stock buyback is when a company purchases a portion of its own shares on the open market with accumulated cash. When this happens, the number of outstanding shares gets reduced and supply & demand comes into play. The result of this action is that there are fewer shares available on the market which then increases the value of each share. In a way, this is a form of returning capital to investors by increasing the value per share.
Some of the common reasons for stock buybacks are when the company believes that the market has priced their 1) shares too cheaply, 2) to reinvest in the company, 3) or to improve some of its fundamental financial ratios.
I have no issue when a company purchases its own shares when it believes that the market has priced it too cheaply. This can also be a positive sign of the management's outlook on the future prospects of the company. I also have no issue when a company purchases its own shares as a means to reinvest in the company in the spirit of improving shareholder value because this could be a positive sign of having a shareholder focused management team in place.
However, I become more critical of the reasoning when a company purchases shares only to improve its financial ratios because this could be a sign of top-level management seeking short-term gains by way of making the quarterly financial statements appear more attractive than what they really are.
This can be misleading for you as an investor because stock buybacks by default will increase the earnings per share even if the actual profits of the business remain the same.
These are some of the primary factors that you should keep in mind as an investor when you are examining the nature of the business that is engaging in stock buybacks.
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Disclaimer: Hudson Wealth Management, LLC (HWM) is a FINRA registered investment adviser firm. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Before investing, consider your investment objectives and HWM's fee schedule. The information provided herein is for illustrative purposes only and does not constitute personalized investment advice, recommendations or solicitations to hold, buy or sell any investment or security of any kind. All images and return figures shown are for illustrative purposes only and are not actual customer or model returns. Past performance does not guarantee future results.
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