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.
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