When companies buy back their own stock, they often cancel those securities, reducing the number of outstanding shares available for trading in the market. That spreads profits over fewer shares, which can boost earnings per share metrics come earnings season and potentially lift the company’s stock price.
“Some of the best and worst investments over the past few decades were heavy buyers of their own stock. Buybacks magnify what’s already there; it can be better for shareholders and good for businesses, but can’t rescue bad companies from their ultimate fates,” said Theresa Shutt, chief investment officer at Harbourfront Wealth Management.
“You really need to look at the business itself.”
Shutt said that buyback programs return excess cash to shareholders, in a way that offers the company more flexibility compared with hiking its dividend, which commits the company to making those payments at regular intervals.
When a buyback occurs, she said shareholders get a bigger ownership stake “without spending a dollar.”
Markets often view buybacks as a positive.
“It can provide support for the share price, that increases demand for the stock, and that can lift the valuation as well,” she said.
But not all buyback programs benefit investors.
She said some companies also use buybacks as a form of “financial engineering” to artificially lift earnings per share metrics.
Keep an eye out for company cutbacks
Investors should also take note if companies are cutting back on investments, research and development or staffing to pay for buybacks, Shutt said. Using debt to fund buybacks is also a potential red flag.
Brian Madden, chief investment officer with First Avenue Investment Counsel, said that while organic growth is the “Holy Grail” of equity investing, not all companies are going to be able to deliver growth at eye-popping levels and may look for other ways to add value for shareholders.
For example, he said some companies may generate a lot of cash but have limited opportunities to reinvest that money into their operations — so they could use a buyback to reward investors instead.
“One alternative would be just to let the cash pile up on your balance sheet, but that’s not ideal in the same way that having idle cash in your brokerage account is not ideal for an individual investor,” Madden said.
“It’s an opportunity cost, and the way the opportunity cost manifests for a company is idle cash doesn’t earn a return.”
What to do when a company announces buybacks?
When a company announces a new buyback program, Madden said the first step for investors is to ask themselves, “Is this anything new?”
“Many companies announce share buybacks every year … for large companies it is the norm that most of them will have a normal course issuer bid authorization, which gives them the right but not the obligation to repurchase their shares,” Madden said.
