Companies sometimes buy back their shares from the open market as a way to increase shareholder value. Distributing dividends is another way of giving value back to the shareholders.
When the board of directors decides to initiate a stock repurchase program, it authorizes a maximum dollar amount of shares or maximum number of shares to be bought back. The target price per share will not be disclosed but it should be close to the recent trading price.
However, just because a stock repurchase plan is announced does not mean that it will be carried out. If the price is not right, like any other investor, the company will not proceed with the buy back.
Firstly, the act of reducing the number of available shares in the market should cause the stock price to rise as basic law of supply and demand would suggest.
The more impactful effect of share buy-backs on stock price is the result of the indirect boost to the earnings per share number - an important metric for stock valuation. The following example illustrates this process.
During the past year, XYZ company booked $10m in profits in which $1m is from interest earned off a $40m cash hoard. The company has 10 million shares outstanding, giving it an EPS of $1 and with a current market price of $20, the stock has a P/E ratio of 20.
The company then announced that it would buy back $40m worth of its own shares Let us assume it is able to buy them at the current market price of $20 and with $40m, the company proceeds to retire 2 million shares.
Assuming no growth in earnings, the company will earn $9m (less the $1m interest income) the following year. With only 8 million shares outstanding, EPS will have grown to $1.13. If the P/E ratio remains at 20, then the stock price should appreciate to $22.60.
Stock repurchase programs are likely to be announced by mature companies whose management feels that the stock is currently underpriced.
Mature companies possess the capability to generate, or have already generated, large cash surplus. Younger companies typically need to reinvest any excess cash to expand the business.
So instead of distributing dividends, management may decide that buybacks are a superior way to distribute value back to the shareholders.
Your new trading account is immediately funded with $5,000 of virtual money which you can use to test out your trading strategies using OptionHouse's virtual trading platform without risking hard-earned money.
Once you start trading for real, your first 100 trades will be commission-free! (Make sure you click thru the link below and quote the promo code '60FREE' during sign-up)Click here to open a trading account at OptionsHouse.com now!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]